What Are Fixed Income Investments?

How Does Fixed Income Investing Work?

Bonds and certificates of deposit (CDs) are the most common fixed income investments. You purchase a bond or CD for a certain amount and earn interest at a set rate. Bonds typically pay interest twice a year; CDs pay interest at maturity. A bond or CD has a set maturity date; if you hold it until maturity, you'll receive its face value (the amount you paid for it).

Suppose you purchase a $1,000 bond with a 5% interest rate and 10-year maturity. For 10 years, you'd receive semi-annual interest payments of $25 ($50 annually or $500 in total). Keep the bond until maturity, and you get the $1,000 back too.

Types of Fixed Income Investments

The most common fixed income investments are bonds, CDs and money market funds.

Bonds

When you buy a bond, you lend money to the bond issuer and receive interest. The annual percentage yield (APY) earned is called the coupon. Most bonds are issued in increments of $1,000 and pay interest every six months. Bonds can mature in one to 30 years.

Bonds are issued by the federal government, corporations and municipalities.

• Treasury bonds: T-bonds are issued by the U.S. Treasury and backed by the federal government's full faith and credit. They're exempt from federal taxes, pay a fixed interest rate and mature in either 20 or 30 years.
• Corporate bonds: Companies sell corporate bonds to finance projects such as research, construction or acquisitions. Interest earned from corporate bonds is taxable. These bonds usually deliver higher returns than Treasury bonds or municipal bonds, but risk levels vary depending on the company's financial stability.
• Municipal bonds: Municipalities issue these bonds to finance projects such as building schools, roads or hospitals. Interest from municipal bonds is usually tax-exempt. There are two kinds of municipal bonds:
  • Revenue bonds finance revenue-generating projects, such as toll roads, and pay interest from those revenues. If the revenues fall short, the bond issuer may have trouble paying.
  • General obligation bonds are backed by the full faith of the issuing authority, which can take all necessary measures to pay them back, including increasing taxes.

Other Treasury Securities

In addition to Treasury bonds, the U.S. Treasury also issues Treasury bills (T-bills) and Treasury notes (T-notes).

• Treasury notes have maturities ranging from two to 10 years, pay interest semi-annually and pay the face value when the note matures.
• Treasury bills have maturities ranging from a few days to 52 weeks. They don't pay interest; instead, you purchase the bill at a discount from its face value and receive the face value at maturity.

Certificates of Deposit (CDs)

A CD is a savings account in which you invest a certain amount with a set maturity date—for example, a $1,000 CD with a five-year maturity. When the CD matures, you receive the amount you paid for it, plus any interest earned.

Most CDs charge penalties for withdrawing money before maturity. CDs generally offer a higher APY than other savings accounts: As of September 19, 2022, the average APY was 0.17 for savings accounts, 0.18 for money market accounts and 0.74 for 60-month CDs. CDs with banks insured by the Federal Deposit Insurance Corporation (FDIC) or credit unions insured by the National Credit Union Administration (NCUA) are insured for up to $250,000 per institution and account type, which means your investment is protected if something happens to the bank before your CD matures.

Money Market Funds

Money market funds are mutual funds that invest in cash equivalents, including T-bonds, T-bills and CDs. They usually have very low returns, but can be a better place to put your cash than a savings account.

Benefits of Fixed Income Investing

Fixed income investments offer several benefits.

• Steady income: Fixed income investments provide predictable income that's valuable in retirement.
• Capital preservation: Fixed income investments can protect savings near or in retirement or help you save for other goals, such as college tuition, at higher interest rates than savings accounts.
• Lower risk: No investment is risk-free, but fixed income investments are typically less affected by economic trends than stocks. Over the 30-year period ending in 2018, at times stock returns have surged by about 40% and plunged by nearly 40%. Bond returns were much more stable, increasing by about 18% and dropping about 3% in the same time period.
• Diversification: Experts generally recommend putting 60% of your investment into stocks and 40% into fixed income investments. Diversifying your portfolio reduces risk, because bond values typically rise when stock values decline.
• Tax benefits: Treasury bonds are exempt from state taxes. Municipal bonds are exempt from federal taxes and sometimes from state taxes too.

Risks of Fixed Income Investments

Fixed income investing also has downsides.

• Lower returns: Fixed income investments are safer than stocks, but returns are generally lower. Over the 30-year period ending in 2018, the average APY was 10.0% for stocks and 6.1% for bonds.
• Credit risk: Treasury bonds and general issue municipal bonds are backed by the full faith of their issuers, but revenue bonds and corporate bonds may default if the issuer runs into financial troubles.
• Interest rate risk: Bond prices fall when interest rates rise and vice versa. While you'll still earn the same interest rate and face value if you hold the bond to maturity, fluctuating interest rates can make selling bonds harder.
• Inflation risk: Low APYs mean your investment may grow at a slower pace than inflation, reducing your purchasing power.
• Illiquidity: Getting full value from a fixed income investment requires waiting until it matures. Sell a bond or withdraw money from a CD before maturity and you could lose money or face penalties.

How to Invest in Fixed Income

To get started with fixed income investments:

• You can buy Treasury securities in increments as small as $100 online at TreasuryDirect.gov. You may be able to purchase municipal bonds directly from the issuing agency. You can also purchase individual corporate or government bonds using a broker.
• Purchasing bonds through a bond mutual fund or exchange-traded fund (ETF) can be a good way to diversify your fixed-income investments. Such funds invest in hundreds of different bonds, minimizing risk from any one bond. They're also professionally managed, but you'll generally pay a fee for this.
• You can buy CDs directly from a bank or credit union or by investing in a money market fund with CDs in its portfolio.

A financial planner or your 401(k) plan's advisors can help you determine the right investment mix for your financial goals.

Secure Your Future

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