Fundamentals of Fixed Income Investments

Reviewed: December 17, 2014
By FinanceWeb

Fixed income investments offer reliable and predictable income streams. In terms of its fundamentals, a fixed-income security is a loan from an investor to a borrower. The bond has a face value, a maturity date, and a coupon rate. The borrower promises to return the loan amount on a date certain, and in between to make payments of an agreed amount of interest. The loan amount is the face value; the incentive for the loan is the interest paid or coupon rate. The interest represents the lender’s profit for the transaction. Fixed income securities can be instruments such municipal bonds, treasury notes, investment grade corporate bonds, money market securities, international bonds, and foreign corporate obligations. Some mutual funds emphasize income over equity or capital growth by basing a large percentage of its investments in fixed income securities; these funds provide an excellent source of reliable income and retirement assets.

Pro’s and Con’s – the Pro’s

Fixed income investments are a helpful addition to nearly any portfolio because they provide income streams. Income or profits from investments create additional flexibility and balance risks of market volatility. With cash income, investors can adjust their portfolios and move quickly on opportunities they might find. Markets change sometimes rapidly and investors with cash reserves can move on opportunities that require a quick response. For those near retirement or in retirement, fixed income improves spending flexibility, and such as Roth IRA accounts, income can continue to grow wealth after retirement to ensure that resources last a lifetime. Bond prices on the secondary market are sensitive to changes in interest rates. In an environment of falling interest rates, long-term bond values can appreciate since current issues would offer less. Some fixed income bonds offer tax advantages. Municipal bonds are tax-free in the state of issuance. Investors can purchase long-term bonds at advantageous prices, in effect far below the face value. Long-term bonds offer high yields to attract buyers.

Pro’s and Con’s – the Con’s

Interest rate changes, credit issues, and currency fluctuations are among the risks associated with fixed income securities. The better returns are on high yield or long-term fixed income instruments. The longer the term, the more likely the prevailing interest rates will affect the price of bonds and create higher paying notes. This situation could be an opportunity cost for those locked-in to long terms on lower paying bonds. Credit issues can affect the value of fixed income instruments. Investors can sell their fixed income paper on the secondary market. Credit issues can lower demand and bid prices for these notes. In international issuers, governments and foreign or multinational corporations, currency fluctuations pose a risk. In broad movements, currencies can affect the value of investments. For example, and investment nominated in Russian Rubles would be a troubled security today as the ruble has fallen dramatically against other benchmark currencies such as the Euro and the U.S. Dollar.

Managing Risks Gaining Rewards

Independent evaluation services such as Moody’s and Standard & Poor’s rate bonds, and offer advice and estimates on credit risk, interest rates, and inflation. These can help guide decisions. Tax brackets may be a factor for some investors, and tax-free investments will have exceptional appeal. Further, one can gain exposure in fixed income securities directly or indirectly. Direct purchases through brokers are one method, but another path is through mutual funds. Some mutual funds use indexes that consist of leading fixed income issuers. While investors will not have to evaluate maturity dates, coupons, and interest rates, they will have the income benefits of a successful index track.