A fixed income is a type of investment whose return is usually fixed or predictable and is paid at a regular frequency like annually, semi-annually, quarterly, or monthly. Along with equities, fixed income forms an important part of the investment market and is used for raising capital by the companies and governments.
When compared with the uncertain returns from equities, commodities, and other investment classes, the predictable and regular returns from fixed-income investments can be used to efficiently diversify your portfolio.
Different Types of Fixed-Income Products
The most common example of a security that yields a fixed income is a bond. Bonds can be issued by federal governments, local municipalities, or major corporations. They are issued for a specific period of time which can range from a few months to a few decades.
Investors can invest in these instruments and they can be paid the specified interest for the period they remain invested.
US Treasuries, which is the American government cabinet level department, is responsible for issuing all kinds of government fixed income securities. The fixed income instruments issued by the US Treasury pay a fixed income to the investors, and include Treasury bills (T-bills), Treasury notes (T-notes), and Treasury bonds (T-bonds).
Treasury bills in general have maturity period of a year or less, while Treasury notes have a maturity period of two to ten years, while treasury bonds have maturity period ranging from 10 to 30 years from their issuance date.
The government of a particular country can also issue sovereign bonds in foreign currencies that enable foreign investors to invest in their local currency. Governments can also issue special types of fixed income instruments like a treasury security that is called Treasury Inflation Protected Securities (TIPS) that offers protection to investors from the negative effects of inflation.
The principal amount of a TIPS instrument increases with inflation and decreases with deflation, as gauged by the Consumer Price Index.
Important Terms
- Issuer/borrower – the issuer is the entity (government, authority, or company) that borrows the funds by issuing the fixed income security. The issuer is also responsible to pay interest at the specified intervals and repay the capital amount to the investors upon maturity of the security.
- Principal – the principal is the amount that an investor receives on the maturity and is also known as the maturity value, face value, or par value.
- Coupon – the coupon is the annual interest related with the fixed income security that the issuer must pay to the lender. The coupon is usually expressed as the percentage of the principal.
- Maturity – the maturity indicates the end of the bond investment tenure; also the date on which the issuer must return the principal to the investor.
Risks
The main risk associated with fixed-income investments is the issuer defaulting on his payments. In addition, there is the credit risk linked to the corporation and it can have varying effects of the valuations of the fixed income instrument until the time to maturity.
It is possible that a company issued a 10-year long bond when it was in its prime, while five years later its business started floundering due to various factors and bond valuations begin decreasing. Even though the company may or may not continue its regular coupon payments, it may become difficult for the investors to sell the bonds in open market at a fair price.