Why Is Fixed Income Called Fixed Income?

Fixed income is a fundamental concept in finance and investing, representing a broad category of investments. These investments are an important component in financial planning, offering a different profile compared to other asset classes. Understanding fixed income helps individuals comprehend how various financial instruments generate returns and contribute to a diversified portfolio.

Defining Fixed Income

The term “fixed income” refers to the predictable and pre-determined stream of payments an investor receives over a specific period. These investments are essentially debt instruments where an investor lends money to an issuer, such as a government or corporation. In exchange for this loan, the issuer agrees to make regular payments of a fixed amount, often called interest or coupon payments, and to return the original principal amount at a set maturity date. This predictability in cash flow provides a known schedule of obligatory payments.

Unlike equity investments, which represent ownership and offer variable returns, fixed income securities do not obligate the issuer to pay dividends. The “fixed” aspect ensures payment amounts and schedules are established at the time of investment and do not fluctuate with market conditions. Should an issuer fail to make a scheduled payment, it constitutes a default with legal consequences. This contrasts with stock dividends, which a company can alter or cancel without default. The certainty of these payments makes fixed income a distinct and more conservative investment choice for many.

Common Fixed Income Investments

Various financial products fall under fixed income, each providing a structured payment stream to investors. Government bonds, such as U.S. Treasury bonds, are debt securities issued by the federal government to finance its operations and are considered to have high credit quality. These bonds offer regular interest payments and a promise to return the principal at maturity, making them a common choice for conservative investors. Similarly, corporate bonds are issued by companies to raise capital, obligating the company to pay interest and repay the principal to bondholders.

Certificates of Deposit (CDs) are offered by banks and credit unions, where an investor deposits money for a fixed period for a fixed interest rate. CDs are often federally insured up to certain limits, providing a secure way to earn a predictable return. Annuities, offered by insurance companies, involve an investor paying a premium for a series of regular payments. Fixed annuities specifically provide a guaranteed interest rate on contributions and a predetermined income stream during the payout phase.

Understanding Fixed Income Returns

Investors in fixed income instruments primarily earn returns through coupon payments and the return of their principal at maturity. Coupon payments are periodic interest payments made by the issuer to the bondholder, calculated as a fixed percentage of the bond’s face value. These payments are typically made on a set schedule, such as semi-annually, and represent the income stream received by the investor. At the end of the investment term, the issuer repays the original principal amount to the investor.

The overall return an investor can expect if they hold a bond until its maturity is measured by its yield to maturity (YTM). YTM considers all future coupon payments and the return of principal, providing a comprehensive annualized rate of return. While scheduled payments are fixed, the market value of fixed income investments can fluctuate, particularly in response to changes in prevailing interest rates. When interest rates rise, the market price of existing bonds with lower fixed coupon rates falls, as new bonds offer more attractive yields. Conversely, if interest rates decline, existing bonds with higher fixed rates become more desirable, causing their market prices to increase. This inverse relationship means an investor who sells a fixed income security before its maturity date might receive more or less than their initial investment, depending on market conditions.