What is fixed income?

Fixed income investments have historically earned investors reliable but low returns, making them popular in many portfolios. To better understand what these types of investments are and how they can strengthen a portfolio, let's review the basics.

What is fixed income?

Fixed income is an asset class, like cash, real estate, commodities, equities and currencies. Fixed income is also considered a debt investment, meaning investors lend money to a business or other entity under the agreement that they expect to receive the full amount back plus interest at the end of a predetermined loan period. Fixed income investors will generally receive interest payments at fixed, periodic intervals until their investment reaches maturity, or the end of the loan term.

For example, let’s say an investor purchases a 10-year bond for $5,000 with an annual 3% interest rate, receiving the interest in two bi-annual payments until the bond reaches maturity. When we do the math, this means that the investor will get a $75 return every six months – $150 for the year in total (i.e., 5,000 x 0.03) – until the loan term ends. Once the bond reaches maturity, the investor will get their initial $5,000 back as well.

There are several fixed income investment products available to investors, including corporate and municipal bonds, exchange-traded funds (ETFs), mutual funds and U.S. Treasury notes, also called U.S. government bonds.

The benefits of fixed income

Investors favor fixed income investments for their relatively low-risk profile and their regular, typically reliable yields. Even though these returns are often lower compared to other investments – like stocks – they can help your portfolio hedge against downside market volatility due to their comparative stability. Additionally, fixed income is intended to return the principal amount at maturity, depending on the claims paying ability of the issuer. This is especially the case with higher-quality, investment-grade-rated options.

There is also a lot of diversity in fixed income, meaning you can create a portfolio with a risk-return ratio that aligns with your financial goals and stage of life (e.g., post-college, new parents, retirement age, etc.). For example, investors tend to skew their portfolio ratio more in favor of fixed income as they near retirement, as a means to potentially generate income during their golden years.

Following this, fixed income investments can be a good source of income and way to hedge against market volatility, especially when investments are structured in a “laddered” portfolio (i.e., a portfolio of fixed income investments with staggered maturity dates).

The risks of fixed income

Like all investments, fixed income carries certain risks, such as credit risk, inflation risk, interest rate risk and a mark-to-market risk.

Credit risk

This is the chance that the bond issuer won’t be able to repay the predetermined obligations. Different fixed income options carry varying credit risks, with lower-quality options usually bearing a greater credit risk than, say, investment-grade-rated options (i.e., fixed income investments with a lower default risk).

Inflation risk

The income earned from these investments is also subject to inflation risk. Let’s say an investor commits capital to a bond for 20 or 30 years at a 5% annual yield, but inflation annually boosts the costs of goods and services by 7% during that time. In this case, the investor will lose money after adjusting for inflation. This example illustrates that while some fixed income investments are designed to mitigate this risk, not all are.

Interest rate risk

Similar to inflation risk, interest rate risk denotes the chance of investment value loss resulting from a fluctuation in interest rates. The longer the loan period is, the higher the interest rate risk usually is as well. One silver lining in this, though, is that prices for existing fixed income investments tend to fall as interest rates rise, allowing investors to purchase new bonds at more attractive levels. However, these lower prices are an adjustment to make older-issue options more competitive against newer-issue options, which typically boast more attractive interest rates.

Mark-to-market risk

If an investor doesn’t want to hold a fixed income investment until maturity, they may be able to sell it. However, fixed income investments are like other securities in that they carry a mark-to-market risk, meaning investors may not be able to sell the bond at the same price they paid for it – especially if inflation or interest rates rise.

Is fixed income protected against loss?

Fixed income investments are not inherently protected against loss. While they are generally considered lower risk compared to equities, they still carry certain risks, as outlined above.

It’s worth noting that no fixed income investments – with the exception of certificates of deposits (CDs) – are insured by the Federal Deposit Insurance Corporation (FDIC). But what does it mean to be FDIC-insured?

A quick history lesson shows us that FDIC insurance – which touts a maximum amount of $250,000 – was instituted to protect American citizens from losing their deposited money at the bank (whether it be in a checking or savings account, a money market deposit account or a CD) in the event of a banking crisis. Interestingly, it was the cataclysmic stock market crash of 1929 – which ushered in the Great Depression – that led to the creation of the FDIC.

In other words, FDIC insurance is there to help account holders get their money back in the face of a crisis that requires a bank to liquidate their assets for cash. If a bank or investment product is not FDIC-insured, there is a chance investors may lose money and not get it back in light of market movement. This goes for the vast majority of fixed income options.

In fact, the closest an investor can get to insuring against market fluctuation is through the Securities Investor Protection Corporation (SIPC), which only insures investor accounts against a failure on behalf of their brokerage firm – not against market fluctuation itself.

SIPC insurance protects against losses that result from company liquidation up to $500,000 (in addition to a $250,000 cash sub-limit), and covers investments like stocks, bonds, Treasury securities and options. Consult with a financial advisor to see if a specific brokerage firm is an SIPC-member institution; if it is, investment options are most likely protected against losses in light of company liquidation on the brokerage firm’s behalf. Investors should be aware that insurance protections, such as FDIC and SIPC, have limitations and do not cover investment losses due to market fluctuations.

Types of fixed-income investments

As mentioned earlier, there are several types of fixed income options available to investors. Generally speaking, investors can purchase fixed income investments through a brokerage firm. Most, if not all, can tout varying maturity dates, interest rates and payment intervals.

Fixed-income funds

It's worth noting the fee structure differences between the two types of funds. Since mutual funds are actively managed, they typically incur higher annual fees – financial advisor services may cost between 0.5%–2% of an entire portfolio, much like mutual fund managers are paid for their services. In comparison, ETFs typically have fewer and more transparent fees; a difference here is that investors usually pay a small brokerage commission on them instead of paying an advisor or fund manager directly from their portfolios.

Certificates of deposit (CDs)

CDs are another relatively low-risk fixed income option; they are considered fixed income investments since they usually pay interest, have a maturity date and are intended to return principal at maturity. However, they function more like savings accounts in that they’re a decent place to “park” cash you don’t immediately need, and they typically generate modest, if not low, returns. Because they behave more like a high-yield savings account, they are the only fixed income option that comes FDIC-insured, as mentioned earlier.

However, CDs tend to perform better in high-interest-rate environments. This is primarily because the Fed fund rate tends to rise during periods of higher inflation – and banks raise interest rates on new CDs in turn to remain attractive to investors.

One major caveat to CDs, though, is the potential for steep penalties in selling them before their maturity date. These penalties can be as severe as forgoing all earned interest on the CD, and perhaps even paying a portion of the principal. However, it’s worth noting that there are differences in penalties between different CD types.

There are two types of CDs investors will likely encounter when exploring fixed income options, both of which are FDIC-insured. Their main differences are seen in costs, risk, selection, transaction and potential benefits.

U.S. government bonds

U.S. government bonds are securities that primarily fund public spending. When investors purchase one of these bonds, they are essentially lending money to the federal government to use on the condition that they’ll receive their principal amount in full plus interest at the end of the loan period. Since U.S. government bonds are issued by the federal government, they are typically exempt from state and municipal taxes.

Treasury securities are an example category of U.S. government bonds, including Treasury bills (T-bills), Treasury notes (T-notes), Treasury bonds (T-bonds), Treasury Inflation-Protected Securities (TIPS), Series EE bonds and Series I bonds. Like other bonds, investors can purchase U.S. government bonds through a brokerage firm. However, they can only directly purchase U.S. savings bonds through TreasuryDirect, which is operated by the U.S. Department of the Treasury.

Municipal bonds

State and local governments, or municipalities, can issue bonds as well. Like U.S. government bonds, municipal bonds are generally less risky than corporate bonds and historically tout a lower default rate. Also unlike other bonds, the interest (i.e., income) on municipal bonds is typically – but not always – exempt from federal taxation.

Risk-wise, they are similar to with U.S. government bonds in that they’re some of the lowest-risk fixed income investment options available. Municipal bonds also come in several varieties. Some are general obligation bonds where a municipality can use any source of revenue to pay the bond. There are also revenue bonds that are tied to a specific project in the municipality such as a toll bridge or local stadium, the revenue from this special project pays bond holders.

Corporate bonds

Similar to how the federal government issues U.S. government bonds to fund public spending, companies issue bonds to fund their business activities. If a corporate bond is “investment-grade-rated,” that means it’s a higher-quality bond that is unlikely to default. Investment-grade-rated corporate bonds are rated Baa3 and above by Moody’s Investors Service, or BBB- and above by S&P Global Ratings – credit ratings typically held by the most creditworthy companies.

In contrast, high-yield bonds (i.e., “junk bonds”) are corporate bonds that are rated as Ba1 or below by Moody’s, and BB+ or below by S&P. This means that they’re riskier than investment-grade-rated corporate bonds, and as a result, are typically cheaper and often carry higher interest rate and default risks. It’s worth noting that since corporate bonds are not backed by a government or municipal entity – and instead have their value and ratings determined by the issuing corporation’s creditworthiness – they are typically regarded as higher-risk than these other fixed income investments.

One unique benefit for corporate bond holders relative to equity holders, though, is that they are typically paid out of a company’s liquidated assets before shareholders in the event of bankruptcy.

Could too much fixed income be a bad thing?

When interest rates moved higher in 2022 and 2023, did you shift some capital to short-term fixed income to take advantage of a historical yield opportunity? Many people did. In this period of heightened market volatility and consecutive Federal Reserve rate hikes, adding to short-term fixed income holdings made sense.

But pan out to a long-term perspective, and it has been a different story. A portfolio that relies too heavily on fixed income can limit an investor’s ability to grow their capital over time and could keep them from meeting their most essential goals.

For example, someone who invested just in Treasury bills (maturing in less than one year) for the last 30 years would have barely preserved their purchasing power. In other words, since fixed income is not historically a source of long-term growth, a portfolio invested exclusively in government bonds would edge out inflation over the long term but fail to grow significantly in real value.

Without enough equities, history tells us, a portfolio lacks a growth engine. Not enough growth means possibly hindering the ability to meet long-term return objectives. That could force investors to take more risk later on or force them to lower their lifetime financial goals.

How to invest in fixed income

There are several ways to invest in fixed income, both directly from the issuer (as with Treasury securities), in taxable brokerage accounts and in tax-advantaged accounts like IRAs. Setting up a taxable or tax-advantaged brokerage account also gives investors access to mutual funds and ETFs that focus on fixed income investments. Investors can, for instance, invest in a fund that only purchases short-term government securities or an ETF that holds high-yield corporate debt.

For years, a rule of thumb was that investors should have their money in a 60/40 portfolio, with 60% of the portfolio going to stocks and 40% going to bonds. However, there are important considerations to review when deciding whether an allocation to fixed income may be appropriate for you specifically. For more information, consult a J.P. Morgan advisor on how to add fixed-income investments to your portfolio.

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