Fixed-income securities represent different types and forms of securities that provide their holders with a steady stream of income from interest payments during a fixed schedule and over a fixed time. Furthermore, upon their maturity, the holders receive the original investment amount. These investments are suitable for certain investment goals and objectives. The different types of fixed-income securities also give investors more options that can help in portfolio diversification.
Explaining the Basics of Fixed-Income Securities: What are Fixed-Income Securities? What are their Examples? Why Should You Invest in Them?
Definition
The central principle behind fixed-income securities is that they provide investors with a fixed and steady stream of income from interest payments. It is also called an income-generating investment. The opposite of these securities are variable-income securities that are characterized by fluctuating payments or do not provide guaranteed payments.
Furthermore, to understand further what fixed-income securities are, it is important to take note of three important terms. These are interest payments, principal payments, and credit ratings. Interest payments or coupons are the payments made to the investors at fixed intervals based on applicable interest rates. The principal payment is the original investment amount that is repaid to the investor once a particular security matures. The interest rates of fixed-income securities are partly determined by the credit rating or financial strength of the issuer.
It is important to think of these securities as loans. To be specific, when an investor buys and holds a fixed-income security, he or she is essentially loaning money to the issuer. Hence, in return, the investor is promised to receive regular interest payments and the original investment amount upon the end of the term of the security.
Types
There is a wide range of securities available for interested investors and different risk profiles. Each has its respective features and level or set of risks. They also have specific purposes or applications. Take note of the following types of fixed-income securities by issuer:
• Government Bonds: These are issued by national or federal governments to raise funds to support national government projects. Specific examples include Treasury Bunds in the United States and Gilts in the United Kingdom. These are considered one of the safest investments due to the low default risk of the issuers.
• Municipal Bonds: Furthermore, aside from bonds issued by national governments, state governments and local government units also issue bonds to finance public projects in their jurisdictions. These are often called municipal bonds. Some municipal bonds provide tax exemption on interest depending on the jurisdiction.
• Corporate Bonds: Another type of fixed-income securities are corporate bonds. These are issued by companies to raise capital. There are different types of bonds that offer fixed interests. The most common ones are called high-yield debt or junk bonds. These provide higher interest payments but have high default risks.
• Preferred Stocks: Some consider preferred stocks as fixed-income securities. Take note that these type of stocks provide their holders with priority claim over profits in the form of dividend payments. The dividend payouts make them similar to traditional fixed-income securities. The main difference is that there is no maturity.
• Time Deposit Accounts: There are banks, financial institutions, and government agencies that provide savings or deposit accounts with fixed interest rates for a predetermined term and in consideration of the minimum deposit amount. Most of these financial products bar depositors from accessing their money before maturity.
• Money Market Funds: Another type of fixed-income securities is money market funds which also represent a type of pooled funds and an example of passive investing. These funds are invested in short-term and highly liquid debt securities like commercial papers, certificates of deposits, and short-term government bonds.
• Asset-Backed Securities: There are also banks that issue asset-backed securities or ABS. An ABS pools together various debt instruments like car loans, mortgages, and student loans, and package them as a single security. It is also structured to provide investors with regular interest payments and a return of principal at maturity.
It is important to note that there are other financial instruments or investment vehicles that provide fixed income. Examples include the cash flow funds of pooled fund products like mutual funds, unit investment trusts, and investment-linked or variable insurance policies. Other examples include annuities. However, because these products are not tradeable assets, meaning that they cannot be bought and then sold in open markets, they are not considered securities.
Applications
The applications of fixed-income securities can represent the core purpose of an investment portfolio or a component of the investment goals and objectives. The purpose essentially varies but rests on the general idea that investing in these securities will provide fixed and recurring income or a passive source of income. The following are the specific applications:
• Passive Income Generation: Investing in fixed-income securities provides investors with a regular and passive source of income. This is attractive for individuals who want to have immediate returns from their investments or for retirees who have a considerable amount of savings and want them to put into productive use.
• Wealth Preservation: These securities can also form part of a savings strategy and overall wealth preservation strategy. Remember that the principal or the amount invested is returned to the investor at maturity. Investing in these securities is suitable for those who are looking for vehicles where they can stash away their funds.
• Portfolio Diversifications: A diversified portfolio should also include investments in fixed-income securities. Some of these securities have lower risks. It is also worth mentioning that income-generating bonds tend to move in a direction opposing stocks. These are ideal for smoothing out the returns of an investment portfolio.
• Hedging Against Inflation: It is also worth noting that these securities provide a better alternative to regular bank or savings accounts because they provide higher returns from interest payments. Nevertheless, because inflation is inevitable, investing in these vehicles can help individuals stabilize their purchasing power.
• Profit Redirection: Another interesting application of fixed-income securities is profit redirection for business owners and business organizations. Remember that are often considered a better alternative than regular savings accounts. A portion of profits can be channeled to these vehicles to build war chest funds.
• Interest Rate Speculation: Most of these securities are tradable. This is particularly true for bonds. Furthermore, because their prices fluctuate based on interest rates, investors can earn a profit from speculation. This involves buying bonds when interest rates are expected to fall and selling them when interest rates are expected to rise.