Fixed income securities provide a steady stream of income for investors. The term fixed income describes two aspects of the investment. First the amount of payment is fixed or known in advance as part of the agreement. Second, the time for payment is also agreed and known in advance. Fixed income securities offer no risk of payment and on-time payments. They are ideal for a reliable income source. One can distinguish fixed income securities from variable income instruments. Payment on variable instruments depends on some other factor such as interest rates or stock market averages. The borower must compute the amount of payment, and is not certain except for an agreed minimum if any.
A Loan to a Worthy Borrower
Beneath the various faces of fixed income securities are some simple transactions. The buyer loans money to the issuer, and the issuer agrees to pay every interest payment and then return the funds. Fixed securities take many forms; the common categories include government bonds, municipal bonds, corporate bonds, and money market securities. The payment provision sometimes takes the form of a coupon that the holder presents for payment, and the time of payment is an essential part of the agreement. If the borrower fails to pay the amount and at the agreed time, then it is in default.
Security and Yield
Because the borrower guarantees payment, the risk on fixed term securities is low; the yield is often smaller than other investments that do not have guaranteed payments. Borrowers who do not have great financial strength must offer higher yields to attract lenders. On one end of the spectrum one finds a U.S. Treasury bond, and at the other end one finds a junk bond, or a bond whose issuer lacks the financial strength of the high asset borrowers. In fixed income securities, higher yields go with lower-rated issuers, and longer terms of investment. The longer term exposes the investor to a greater chance of market changes.
Risks, Term And Interest Rates
Buying fixed income securities is a balancing act. The guaranteed parts of income and amount are good, however, there are risks even with the highest rated issuers. The risk comes from the loss of opportunity when funds are tied to a term of the investment, and the market offers higher paying investments of the same or similar quality. For example, a ten-year Treasury Bill might pay three percent. This rate may be an above average yield at the time of purchase. However, if interest rates rise sharply in the second year, then high-value corporate bonds might have to pay five percent to attract investors. While invested at three percent, one in effect is losing two percent per year. The opportunity loss is a factor to consider when deciding on the term of the investment.
Alternative Investment Approaches
Professional rating services provide information about issuers and credit risk which are essential for sound investment decisions. Many investors see fixed income securities as potentially limiting in a time of uncertainty about the movement of interest rates or the general conditions in the economy. One can add fixed income securities in a mix of investments by balancing an individual portfolio with some bonds. One can also invest in a mix of fixed and equity securities by investing in mutual funds. Many mutual funds carry significant amounts of fixed income securities in their portfolios.