What Is Fixed Income? Types and Key Concepts

Fixed income refers to a category of investments designed to provide investors with a regular, predictable stream of payments over a set period. These investments typically involve lending money to an entity, such as a government or a corporation, in exchange for scheduled returns. The consistent nature of these payments makes fixed income an appealing option for those seeking stability and a defined income stream from their portfolio.

Understanding Fixed Income Basics

Fixed income investments involve a loan from an investor to a borrower, such as a government, municipality, or corporation. In return, the borrower commits to making periodic interest payments and repaying the original amount borrowed at a predetermined future date.

The core components of a fixed income investment include the principal, the interest payment, and the maturity date. The principal, also known as the face value or par value, is the initial amount loaned by the investor and the sum that will be returned at the end of the investment term. Interest payments, often called coupon payments, are the regular disbursements made by the borrower to the investor. These payments are typically fixed in amount and occur on a set schedule, such as semi-annually or annually.

The maturity date is a specific future date on which the borrower is obligated to repay the principal amount to the investor. This date marks the end of the loan term, after which the investor receives their original investment back.

Common Types of Fixed Income Investments

Various types of fixed income investments are available, differing in issuer, risk profile, and characteristics. They are designed to provide consistent income and help preserve capital.

Government bonds are issued by federal, state, or local governments to finance public projects or operations. U.S. Treasury bonds, notes, and bills are issued by the U.S. Department of the Treasury and are considered to have high credit quality because they are backed by the full faith and credit of the U.S. government. Treasury bills are short-term, maturing within a year, while Treasury notes have maturities between two and ten years, and Treasury bonds mature in 20 or 30 years.

Corporate bonds are issued by companies to raise capital for business expansion, operations, or other corporate needs. These bonds typically offer higher interest rates than government bonds due to their increased risk, as the financial health of corporations can vary significantly. Municipal bonds, often referred to as “munis,” are issued by state and local governments and their agencies. A notable feature of many municipal bonds is that their interest income may be exempt from federal income taxes, and sometimes from state and local taxes as well, depending on where the investor resides and the bond is issued.

Certificates of Deposit (CDs) are another common fixed income option, typically offered by banks and credit unions. When an investor purchases a CD, they deposit a sum of money for a fixed period at a fixed interest rate. Most CDs offered by banks are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor, per insured bank, for each account ownership category. This insurance provides a high degree of safety, making CDs among the most secure investment vehicles available.

Money market accounts and money market funds also fall under the umbrella of fixed income, though they are generally more liquid and offer lower returns than longer-term bonds or CDs. Money market accounts are savings accounts that usually offer a variable interest rate and allow for limited check-writing capabilities. Money market funds are mutual funds that invest in highly liquid, short-term debt instruments, such as Treasury bills, commercial paper, and certificates of deposit. These funds aim to maintain a stable net asset value, often $1.00 per share, providing both liquidity and a modest return.

Key Concepts in Fixed Income

Understanding specific financial concepts helps in evaluating fixed income investments. These concepts provide insight into how investments are priced, their potential returns, and the risks involved.

Yield is an important measure in fixed income, representing the return an investor receives. Different types of yield exist, such as current yield and yield to maturity. Current yield calculates the annual interest payment relative to the bond’s current market price. Yield to maturity (YTM) offers a more comprehensive measure, representing the total return an investor can expect if they hold the bond until it matures, taking into account the bond’s current market price, par value, coupon interest rate, and time to maturity.

Credit risk is the possibility that the borrower will fail to make timely interest payments or repay the principal amount at maturity. Independent credit rating agencies, such as Standard & Poor’s, Moody’s, and Fitch Ratings, assign credit ratings to fixed income securities. These ratings reflect the agency’s opinion on the issuer’s ability to meet its financial obligations, with higher ratings indicating lower credit risk. Bonds with lower credit ratings, often referred to as “junk bonds,” typically offer higher interest rates to compensate investors for the increased risk of default.

Interest rate risk refers to the risk that changes in prevailing interest rates will affect the value of existing fixed income investments. When market interest rates rise, the value of existing bonds with lower fixed interest rates typically falls, as new bonds are issued with more attractive yields. Conversely, when market interest rates decline, the value of existing bonds with higher fixed interest rates tends to increase. This inverse relationship between bond prices and interest rates is an important consideration for investors, especially for longer-term fixed income securities, which generally have greater interest rate sensitivity.

Comparing Fixed Income and Stocks

Fixed income investments and stocks represent distinct asset classes with different characteristics and roles within an investment portfolio. Their fundamental differences lie in how returns are generated, their typical risk profiles, and their primary purposes for investors.

Fixed income investments generate returns primarily through regular interest payments and the return of principal at maturity. They are debt instruments, meaning an investor lends money to an issuer and receives predictable income. Stocks, or equities, represent ownership in a company, and their returns are primarily derived from capital appreciation—an increase in the stock’s market price—and potential dividends, which are not guaranteed.

In terms of risk, fixed income securities are generally considered less volatile and carry lower risk compared to stocks. This is because the income stream is typically fixed and the return of principal is expected. Stocks, however, are subject to greater price fluctuations based on company performance, economic conditions, and market sentiment, leading to higher potential returns but also higher potential losses.

Fixed income investments often serve as a means for income generation and capital preservation within a portfolio. They can provide a stable base and help diversify a portfolio, potentially offsetting the volatility of equity holdings. Stocks, on the other hand, are typically favored by investors seeking long-term growth and capital appreciation. While both can contribute to a diversified investment strategy, they fulfill different objectives based on their inherent risk-return profiles.