Fixed Income Securities

Fixed income securities (or debt) securities, such as bonds and notes, are issued by corporations, federal and state governments and their agencies, and municipalities. The issuer is essentially borrowing money from the investor. In return for this ‘loan,’ the company promises to repay the face amount (the principal value) at a specified date in the future (maturity date) and to make periodic interest payments, usually semiannually, at a specified rate (coupon rate) at specified dates.

For example, a $1000 bond with a 6% coupon would pay $60 per year (6% x $1,000), or $30 semiannually. This stream of income is a major advantage to owners of bonds. Of course, that income stream is only dependable if the issuer is capable of paying it when due. Because the typical debt instrument has a fixed coupon rate, the market value of the security increases when prevailing market interest rates decline and conversely declines when interest rates move higher.

Why you should have fixed income securities in your portfolio

Investors look to interest payments and possible appreciation in the value of their debt securities, if sold at a profit prior to maturity, as sources of total return. Total return is the best measure of return from fixed income-securities and is incorporated in the yield-to-maturity calculation commonly used when quoting bond yields.

Taxation of interest income depends on the issuer. Interest income from US government direct issues, like Treasury securities, is taxable at the federal level but free from state and local income tax. Corporate issues pay interest income that is taxable at the federal, state, and local levels.

In the case of municipal bonds, the interest is exempt from federal and, if owned by residents of the issuer, can be free from state and local taxation. For example, a Phoenix bond is free from income taxation by the US government, the state of Arizona and the city of Phoenix. This exemption can make the after-tax yield higher than the yield on taxable securities for investors in high income tax brackets.

Bonds and Risk

Although bond prices generally fluctuate less than stock prices and are widely considered to be safer than stocks, one disadvantage is their modest rate of return compared to stocks. Long-term corporate bonds have averaged only a 6.1% annual return from 1926-2021. Very few people expect the return of long-term corporate bonds to approach this level in the near future. Are their other risk to look out for when investing in bonds?

Reinvestment and Call Risk

Many bonds, especially municipal and corporate bonds, have call provisions allowing the issuer to pay back principal before the maturity date. The call provisions are exercised when issuers can refinance at a rate lower than the coupon rate. This is an advantage for the issuer, but a disadvantage for bondholders because the latter has a high-yielding bond called away, leaving them to reinvest at lower interest rates. This is called reinvestment risk. Bonds that are likely to be called are said to have call risk.

Bond Maturity and Interest Rate Risk

An important feature of a bond is its maturity, which is the time until the bond’s principal is repaid. (Some debt instruments with maturities between one year and 10 years are called notes.) Maturities are important, not only because they indicate when the principal is to be repaid to the bondholder, but also because they are directly related to the bond’s price movements with a given change in interest rates.

The longer the years to maturity, the more the bond will increase or decrease in market value as interest rates change. Bonds with longer maturities also usually pay higher rates of interest than similar bonds with shorter maturities. Too many inexperienced investors focus on that higher rate and overlook the increased risk, called interest rate risk, which is the degree to which the bond’s price can fall if interest rates increase.

Inflation Risk

Inflation risk is the risk that inflation will reduce the purchasing power of the fixed income securities and fixed principal payments when they are received. Other risks with fixed income securities are default risk, which generally can e reduced by purchasing only high-rated (investment grade) bonds (BBB, A, AA, AAA).