When business leaders are deciding how to finance their operation, they typically use two ways to fund operations when raising money from investors: equity and fixed income. Equity gives investors actual ownership in the enterprise, whereas fixedincome, or bonds, are “loaner investments,” through which the company becomes a borrower, with investors lending money in exchange for a certain “fixed rate” of interest. A diversified portfolio would contain both owner and loaner investments.
From the investor’s point of view, bonds are usually considered more stable, offering a steadier stream of income and, at least typically, less volatility when compared with stocks. But when interest rates rise, bond holders see the value on their fixed-income holdings fall. Conversely, when interest rates fall, existing bonds become more attractive (because a higher rate of interest has been “locked in”), and bond prices tend to rise. During 2020, for example, bond prices rose dramatically, while bond yields fell to historic lows.
Fixed income investments come in different varieties (based on which entity is doing the borrowing and the terms of the “loans”):
- S. Treasury bonds
- Government agency bonds
- Municipal bonds (issued by a city, state, or an agency)
- Corporate bonds
- Mortgage-backed securities
- Certificates of deposit
- Convertible bonds
- High-yield bonds
- Emerging market and global bonds
In any of these categories of “loaners,” investors might choose individual bonds, or invest in portfolios of bonds in the form of mutual funds or Exchange-traded funds (ETFs).
Bonds are issued with maturity dates ranging from one year to thirty years. At maturity,the issuer of the security must pay the investor the face value of the bond. The shorter the time until maturity, the lower the interest rate will be. Remember, up until the maturity date, the price of the bond will fluctuate, while the quarterly, semi-annual, or annual interest payment remains fixed.
Municipal bonds are often sought after by investors who want to save on taxes, because the interest payments they generate are typically exempt from federal income tax. (Why the special treatment? City and state governments are raising capital for public projects, including schools, utilities, and improvements.)
Bonds have credit ratings published by agencies such as Standard & Poor’s and Moody’s, assessing the likelihood that, upon the bond’s maturity, the investor will receive the full face value of that bond. Assigned ratings, from best to worst, go from AAA or Aaa down to BBB- for investment grade, with the lowest-rated bonds starting at BB+ called “junk.”The ratings serve as a reminder that investors must consider the potential for the borrower to default on the loan.
Just as it is important to diversify a stock portfolio, it’s important to do the same with bonds. Diversifying among different types of loaner securities—from different issuers, with different maturity dates—is the way investors can “get the fix” on fixed income investing!