Fixed income investing explained: How to build a better portfolio using this strategy

This post was originally published on this site

Putting your money in the market means you can lose some or all of it with no clear indication of when you’ll make up those losses, if ever. That’s why it’s important to balance your portfolio with lower-risk assets. And fixed income investing is one way to do that. 

What is fixed income investing?

Fixed income investing is an investment approach that involves putting your money in low-risk assets that provide a fixed stream of income through interest or dividends. This strategy allows you to mitigate market risk, earn passive income, and preserve capital. However, because these types of investments are generally low-risk, they usually won’t contribute to a lot of portfolio growth. 

Essentially, fixed income investing means loaning money—whether it’s to a bank, government entity, or corporation—and receiving interest in the interim. As long as things go according to plan, your principal investment is preserved, according to Scott Kyle, CEO and chief investment officer at Coastwise Capital Group. However, fixed income investing isn’t foolproof; you can lose part of your principal investment if, for example, the issuer of the security defaults on its payments.

Types of fixed income investments 

There are a number of investments that fall under the umbrella of fixed income, including:

• Bonds: These can include government, corporate, and municipal bonds. When a bond is issued, the borrower agrees to pay the investor a fixed rate of interest, known as the coupon rate, over a set period of time. At the end of the term, the borrower repays the investor the principal amount of the bond. 
• Certificates of deposit (CDs): A CD is a type of deposit account that pays interest in exchange for agreeing to keep your money in the bank for a specific period of time. Longer-term CDs tend to pay higher rates.. 
• Money market funds: These are a type of mutual fund that invests in short-term, low-risk debt securities, such as Treasury bills.  
• Bond mutual funds: Bond mutual funds are similar to stock mutual funds. You pool your money with other investors, and that money is invested in a variety of bonds. 
• Bond exchange-traded funds (ETFs): Bond ETFs are funds that are traded on a stock  exchange and hold an underlying portfolio of bonds.  

Potential benefits of fixed income investing 

One of the biggest benefits of fixed income investing is that it’s considered low-risk. That’s not to say there is zero risk associated with investing in fixed income assets, but these investments are typically less volatile and provide a predictable rate of return.

Fixed income investing can also provide a steady source of passive income via interest or dividends. “That’s why fixed income is a great way to allocate capital, because it provides both income and return with stability,” Kyle says. 

Additionally, investing in fixed income can help balance out market volatility. “Fixed income is a key part of investing in a diversified portfolio,” says Tracey Manzi, senior investment strategist and chartered financial analyst at Raymond James, a financial services firm. She adds that fixed income is one of three key portfolio building blocks, along with cash and equities. 

Despite these benefits, the portion of your investments that are dedicated to fixed income vs. riskier securities will depend on your goals and where you are in your financial life, according to Kyle. 

If you’re in your 20s, for example, you can invest more aggressively since you have plenty of time to make up for losses. On the other hand, if you’re getting closer to retirement or already retired, that calls for a different approach. 

“Presumably, you’ve built up a bunch of capital so you’re focused less on growing your money than preserving your money, and having your money work for you to pay your bills,” Kyle says. “You’re not focused on growth, you’re more focused on income and stability.” 

Risks associated with fixed income investing 

Every investment has some risk, Manzi says. Even though fixed income assets are generally safer than equities, it’s still possible to lose money. Manzi notes that last year was a perfect example of that—2022 was the worst year on record for bonds, thanks to rapidly rising interest rates, which pushed bond yields down.

In fact, interest rate risk—which Manzi says goes hand-in-hand with inflation risk—is one of the biggest threats to fixed income investors. When the rate of inflation goes up, the Federal Reserve raises its target rate in an attempt to rein it in. However, bond yields have an inverse relationship with interest rates, meaning they lose value as interest rates rise. Kyle notes that this may not necessarily be a big deal, unless you need to sell a bond before the maturity date. “Then you’re losing a lot more in the value of the bond than you gain with the interest,” he says.

Another concern is default risk, which occurs when the borrower (a.k.a. the bank or bond issuer) is unable to make interest payments, or repay the principal of a loan or bond when it’s due. “In some cases, bonds go belly-up,” Kyle says. Though rare, this is usually more common with higher-risk corporate bonds. The U.S. government, on the other hand, has never defaulted on a bond.

The takeaway 

Fixed income investing is a great way to earn consistent investment income and reduce risk. Investments such as bonds, CDs, and money market funds can help diversify your portfolio and protect your capital when the market fluctuates. This is especially important for older investors nearing retirement who can’t afford to lose a chunk of their savings due to swings in the stock market. However, if you’re a younger investor with a long time horizon, fixed income assets should take up a smaller percentage of your portfolio.