Risk is about losing money for investors, which is why the reliability and predictability of fixed income can be a draw to many.
Fixed income does what it says on the tin; it provides investors with a regular and predictable income and real return. The income is paid by the issuer and is earned by the investor, who lends the issuer money.
As fixed income poses less risk than equities or derivatives, investors who prioritise protecting the value of their money and want to earn a steady income tend to prefer fixed income investments.
Fixed income bonds
Bonds are one of the most common instruments on the financial markets. Money is loaned by an investor to a government or company, to pay bills, raise cash and make new investments.
When you buy a bond, you expect the loan to be repaid in full on a specific date – this is known as maturity. Investors also expect to earn a regular income throughout the life of the bond from the coupon payments. These coupon payments should look to offset the impact of inflation, at the very least.
What are the risks to investing in bonds?
Although bonds are often seen as a safe haven for their reliability, there are risks to investing in bonds, namely credit risk, interest rate risk and inflation.
There’s always the chance the lender won’t be able to afford repaying the loan at maturity, or keep up with your coupon payments. Bonds are ranked according to their risk of default, the higher the risk the cheaper they are.
As bonds can be bought and sold throughout their financial life, there’s a chance any changes in the interest rate environment could also impact the bond value.
For example, imagine you earn 3% interest on your government bond, but interest rates rise to 5%. New bonds will offer higher coupon rates than what you’re currently getting, so you’re probably going to look for better returns elsewhere. As investors look for better coupon rates, demand for your bond will fall – reducing the price.
There’s also the chance that inflation might outstrip the returns offered from your bond. If this happens, your money will have lost purchasing power – even if it shows positive gains.
Make sure you include the impact of inflation when you make your calculations, or consider investing in Treasury Inflation-Protected Securities (TIPS).
What other fixed income investments are there?
Whilst bonds are the most popular fixed income investments, you can also invest in fixed income mutual funds, exchange traded funds, contract for difference and money market funds.
Bond mutual funds invest in individual bonds. Investors might like them because they generally pay regular dividends thanks to the income generated from the bonds in the portfolio. They can also be good for capital preservation.
Whilst you can get access to a number of different bonds through one investment, you can’t buy or sell your investments quickly. You won’t always know what you’re invested in and management fees can also be expensive.
Exchange traded funds
Fixed income ETFs are a basket of fixed income securities that can be traded within seconds on an exchange. ETFs are easier to buy and sell than mutual funds and you can monitor the changing price throughout the day.
ETFs are passive investments, which mean they track an investment or index and aim to replicate its performance. This means they are lower-cost than mutual funds, which allows investors to keep more of their money.
Whilst you shouldn’t expect market-beating returns, passive investments can outperform actively managed funds and you can also see what you’re invested in.
Building a fixed income portfolio
When an investor wants to build a fixed income portfolio, they’re after stable and reliable returns.
This strategy usually suits an investor that has a shorter time horizon, or someone who is very risk-averse. Whether you’re saving to move house, for a wedding, or if retirement is around the corner, you’ll want to protect the value of your money.
Whilst you want to preserve the value of your money, you wouldn’t be able to offset the impact of inflation without taking on some risk.
Fixed income can also be used to help manage the risk in portfolios that are looking for higher returns by adding diversification. The predictable nature of the asset can complement a portfolio with a greater focus on equities, for example, and help investors reach their goals.
Investing is personal, so the way you invest should be too. But knowing what investments you should have in your portfolio and how to allocate your money can be difficult to do on your own.
It all depends on your investor profile, which is influenced by what your saving for, when you’ll want your money and your attitude to risk. Understanding this is one of the first steps to reaching your financial goals.