Fixed income is an investment that provides a stable cash flow. Common examples include defined benefit pensions, bonds, and loans. Fixed income also includes certificates of deposit, savings accounts, money market funds, and fixed-income annuities. You can invest in fixed income securities through bond mutual funds, exchange-traded funds (ETFs), and fixed income derivatives.
Types of Fixed Income
There are four main categories of fixed income investments. Short-term products offer low returns but tie your money up for a few months at most. Long-term products pay higher rates but require you to keep your money invested for years.
Short-Term
Interest rates on short-term fixed income accounts reflect the federal funds rate. When federal deposit rates were cut to zero in 2008, these products offered very low interest rates. To earn a higher return, many individual investors shifted from short-term investments to long-term investments. Companies use short-term loans to cover cash liquidity needed for daily operations.
Examples include:
- Savings accounts: The bank pays you a fixed interest rate based on the federal deposit rate. You can add or withdraw money as you wish.
- Money market accounts: The bank pays you a slightly higher fixed interest rate. In return, you must maintain a minimum deposit amount. There is a limit to the number of transactions you can make per year.
- Certificates of deposit: You must keep your money invested for an agreed-upon period to receive the promised rate of return.
- Money market funds: These are investment funds that invest in a variety of short-term investments. You earn a fixed return based on short-term securities. These include treasury bills, bonds issued by federal agencies, and euro deposits. They also include repurchase agreements, certificates of deposit, and commercial paper. They are based on obligations of states and cities or other types of municipal agencies.
- Short-term bond funds: These investment funds invest in bonds with maturities ranging from one to four years, primarily investment-grade corporate bonds.
Long-Term
This type of instrument reflects a debt agreement between the issuing company or government and the investor (creditor). For corporate issuances, the interest rates offered depend on treasury rates as well as the credit risk and duration of the debt.
Investment-grade bonds are generally considered stable investments. For this reason, they offer lower returns than higher-risk assets, such as stocks. Historically, bond prices have shown little correlation with stock prices, even negative correlation during recession periods. However, this has changed in recent years, where the two asset classes have shown a much higher degree of correlation.
Here are different types of bonds:
- Government bonds are the safest, as they are guaranteed. Because they are the safest, they offer the lowest returns. U.S. Treasury bonds are the most well-known, with a total value of $16.6 trillion in 2019.
- Savings bonds are also guaranteed by the U.S. Treasury. They are designed for small investors.
- Municipal bonds are sold by cities, states, and other municipalities. Corporations issue corporate bonds when they need cash but do not want to issue stock. The current value of these bonds outstanding is $8.1 trillion.
- Preferred stocks offer regular dividends, even though they are a type of stock. Convertible bonds are bonds that can be converted to stock. Regular dividend-paying stocks are often replaced by fixed income bonds. Although they are not technically fixed income, portfolio managers often treat them as such.
- They are considered
European bonds are the common name for euro bonds. They are international bonds denominated in a foreign currency other than the local currency of the market in which they are issued.
Fixed Income Derivatives
There are many financial derivatives whose value is based on fixed income products. They have higher return potential because you invest less of your money. However, if you lose money, you could lose more than your initial investment. Advanced investors, corporations, and financial institutions use these derivatives to hedge against losses.
Here are some fixed income derivatives:
- Options give the buyer the right, but not the obligation, to trade a bond at a specified price on a future agreed-upon date. The right to buy a bond is called a call option. The right to sell a bond is called a put option. They are traded on an organized exchange.
- Futures contracts are similar to options, except that they obligate participants to complete the trade. They are traded on an exchange.
- Forward contracts are similar to futures contracts, except they are not traded on an exchange. Instead, they are traded over-the-counter, either directly between the parties or through a bank. They are often highly customized to the specific needs of both parties.
- Mortgage-backed securities derive their value from pools of mortgage loans. Like bonds, they offer a return based on treasury prices as well as the specific risks of the underlying assets.
- Debt-related financial obligations derive their value from a variety of underlying assets, including corporate bank loans, auto loans, and credit card debt.
- Asset-backed commercial paper are one-year maturity corporate bonds. They are based on the underlying business assets. These assets include real estate, corporate fleet vehicles, or other business properties.
- Interest rate swaps are contracts that allow investors to exchange future interest payments (or receipts). Often, this arrangement involves a payer (or receiver) of a fixed stream of interest from fixed-rate bonds and a payer (or receiver) of a fixed stream of interest from a floating rate. They are traded over-the-counter. Interest rate options are options on a basic interest rate swap – a derivative based on a derivative.
- Total return swaps are like interest rate swaps, except that they involve the exchange of cash flows linked to an asset and another linked to an index or benchmark (like the S&P 500).
Fixed Income Streams from Third Parties
Some fixed income streams do not depend on the investment’s value. Instead, payments are guaranteed by a third party.
Social Security
Pays fixed amounts after a certain age. It is guaranteed by the federal government and calculated based on the payroll taxes you have paid. It is managed by the Social Security Administration.
Retirement
Pays fixed amounts guaranteed by your employer based on the number of years you have worked and your salary. Companies, unions, and governments use pension funds to ensure that the necessary amounts are available for payouts. As more workers retire, there are fewer companies offering these benefits.
Annuities with Fixed Payments
Fixed payment annuities are an insurance product that guarantees you a fixed payment over an agreed-upon period. These products are becoming increasingly popular as fewer workers receive pensions. Variable annuities can provide long-term improvement in the event of a significant stock market increase, but they also provide a fixed baseline level of income.
How
Fixed Income Affects the U.S. Economy
Fixed income provides most of the liquidity that keeps the U.S. economy running smoothly. Companies turn to the bond markets to raise money for growth (for short-term needs, they use the money markets, which also consist of short-term fixed income securities). They use money market instruments to obtain the cash needed for daily operations.
Treasury bonds, notes, and bills set a benchmark for other interest rates. When demand for Treasury debt falls, yields rise. Investors demand higher interest rates on other fixed income products. This, in turn, raises interest rates on everything from auto loans to student loans to mortgages.
Inflation
Low-interest rates can lead to inflation. This is because there is too much liquidity chasing too few goods. If inflation does not show in consumer spending, it may lead to the creation of asset bubbles in investments.
In some cases, Treasury yields can be used to forecast future economic conditions. For example, the inverted yield curve signals
Source: https://www.thebalancemoney.com/what-is-fixed-income-3306250
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