What is Fixed Income?

Fixed income is a broad term defining investments that have a guaranteed payment schedule. Generally, fixed income securities have lower returns and less risk. As income from work fades away, having fixed income to meet your fixed expenses can be a way to provide for a more predictable retirement.

Bonds

Bonds are the most common form of fixed income. Simply put, when you purchase a bond, you are providing cash to a company or government who is taking on debt (the loan you gave them).

What makes it fixed income?

When a person or organization chooses to issue a bond (also known as taking on debt) they agree to certain guarantees on that money. Every bond has a rate of payment (also known as the coupon rate) that it pays to the holder. This coupon rate provides the person/organization who loaned it money a fixed income or payment.

Just like if you loaned your hypothetical brother Ben a $100 and he paid you back $10 (10% coupon rate) every year for 10 years. That $10 is the fixed income.

Common forms of bonds

Treasury Bonds – these are bonds issued by the US government and considered the safest type of bond because the government can raise taxes or print money if they can’t meet their bond obligations (aka. Pay people back). Because of their safety, treasury bonds usually have the lowest returns.

Municipal Bonds – these are bonds issued by a local municipality or city. Like US Treasury Bonds, these are a less risky option because the local government can raise taxes as necessary. Municipal Bonds have the added benefit of carrying federal tax-free returns, which can make them attractive to those in a high tax bracket.

Corporate Bonds – these bonds are issued by corporations. They vary dramatically in risk level, returns and are judged by bond rating agencies. Typically, the safest bonds would receive a ‘AAA’ rating but have lower return. A bond with a ‘BBB’ rating is still considered investment grade but may carry some risk. Below a ‘BBB’ rating bonds become “junk bonds.” Almost all corporate bonds will offer better returns than a government bond because there is a higher risk of a company going out of business than the US government.

Junk Bonds – these bonds are issued by corporations but are judged to have a very high chance of default. Default is when the bond issuer cannot fulfill its obligation to pay the loan back. In the event of default, the bond holders may receive some or none of their original investment. These bonds offer the highest rate of return but also run the risk of losing the entire investment.

This makes sense because if you had another hypothetical brother named Mike who was not likely to pay you back your $100, you may charge him 50% interest every year instead of 10% to brother Ben.

Bond Strategies

Likely, a combination of different bonds will be held by your portfolio and not just one type. Like asset allocation in stocks, holding different types of bonds can reduce risk and balance out returns.

Additionally, a common strategy is Bond Laddering. Bonds each a have a maturity date or date when the principal amount is returned to the owner of the bond. Bond laddering is a strategy of buying bonds with different maturity dates to reduce interest rate fluctuations. Additionally, this prevents reinvestment risk by spreading out the return of principal and subsequent reinvestment over different years.

Certificate of Deposit

Certificates of Deposit or CD’s work very similar to bonds. Usually, you deposit money with a bank or financial institution and guarantee to leave the money there until its maturity. They will pay you a small percentage of interest to do so.

If you choose to withdraw the money early, you will forfeit the interest earned and could pay a penalty. This is a very low risk option to make a small return on cash without risk in the market. Additionally, CDs are FDIC insured like the money in your savings account.

Fixed Annuities

Fixed annuities also provide a guaranteed form of income to the purchaser. Unlike being an investment security, annuities are provided through an insurance company. Like bonds, fixed annuities have very clear payment terms and schedules. Annuities uniquely offer payments for life while bonds hit maturity and must return the principal. Additionally, annuities can be funded tax free with the income being tax free. While annuities are generally safer because they have no default risk, returns are usually lower because of the fees charged to have one.

It is important to note that with fixed income securities like CDs, Bonds, and Fixed Annuities you are particularly exposed to inflationary risk. This is the risk that due to inflation, your principal will have less purchasing power later than it did when you bought it.

Real Estate

Real Estate can hold many similar characteristics to fixed income securities. While personal ownership of real estate can be a great investment, lets focus on investment securities that give you access to the characteristics of real estate investing without buying an actual property.

REITs

Real Estate Investment Trusts are securities that trade just like a stock on the open market. REITs hold real estate assets and distribute the profit back to the owners . By law they have to distribute 90% each year actually. REITs can provide a strong income stream, without the management or selection of property that comes with personal ownership.

Beyond that, owning a share in a REIT is like a stock, so it does not require the same commitment of capital that comes with personal real estate ownership. The downside is that owning a REIT does not provide all the taxable benefits that come along with personal ownership of a property.

Syndicates

Syndication is a formal process of pooling resources to buy an asset or make an investment. Syndications also buy real estate and provide many of the upsides that are associated with personal ownership. The downside is that syndication is only available to accredited investors.

Takeaways

Fixed income securities are generally lower risk compared to stocks because you know what you are getting each year in interest. It can also be valuable to ensure your fixed expenses are covered during retirement, which is why bonds or REITs or annuities are often used. Regardless of the tool, you want to make sure the tool you choose is aligned with your overall retirement income strategy.

Disclaimer: This post is for informational purposes only and is never to be taken as advice or a recommendation. Talk to a tax or legal professional to determine how this information best applies to your personal situation.