Fixed Income Investment
A fixed income investment is one that gives you a fixed income at a fixed rate of interest throughout the tenure of the investment. As an investment rule, you must keep a small percentage of your savings in a fixed income investment. This will shield you against the variations in income from investment in stocks. Though the returns from investment in equity are definitely higher, they are also riskier. Bonds are a safer option with a guaranteed return and almost no risk, though the income may be substantially lower then investment in stocks.
Reasons to invest in fixed income investments:
There are different types of fixed income investment, namely bonds. The federal government, a federal agency, or a local or state government guarantees government bonds. The bond issuer promises to pay the investor a fixed interest income at specified intervals of time. The issuer will also pay back the invested principal at the due date of maturity. Investing in bonds diversifies your risk and gives you a constant income. Investors who save money for a specific purpose at a specific time will also invest in bonds, for example those planning to buy a second home or planning a childs college education. Bonds are a favorite with investors planning for retirement as a source of steady income in their post retirement years. The only disadvantage on investing in fixed income investment is that the income does not account for rising inflation, so your returns will diminish in case inflation rises during the tenure of the bond. Some analysts feel that the returns from bonds decrease with rising interest rates. However if you hold bonds over the long term, you can reinvest the principle of the bond at the higher rates of interest prevailing in the market, thus increasing your income.
Returns from fixed income investments:
Investment grade bonds, guaranteed by the government offer moderate risk and moderate returns. The returns from bonds or bond-based mutual funds can be measured against the Lehman Brothers bond index. This index comprises government and high-quality corporate securities, agency mortgage pass-through securities, asset-backed securities, and commercial mortgage-backed securities. Studies over twenty-five years prove that for more than twenty years bonds offer good returns without any loss. Therefore, as compared to investment in stocks and cash, bonds offer better returns and mitigate the principal loss risk to the investor.
The different types of fixed income investments:
* Investors who have difficulty in understanding the changes in the bond market can invest in bond based mutual funds. These funds invest in different sectors at different coupon rates to give assured returns to the investor over a long term horizon. They are convenient as the bond manager changes the investment in the bond market to give you the best possible returns.
* Treasury bonds are guaranteed by the US treasury department and are almost risk-free. Different types of treasury bonds are available to meet your investment needs.
* Different government agencies issue bonds with a higher rate of return than treasury bonds.
* Mortgage backed bonds give higher rates of return but are riskier. These are based on mortgages bought from the U.S. government.
* Municipal bonds are issued by local authorities and offer tax benefits to the investor. The investor is exempt from both federal and local taxes for this investment.
* Corporate bonds issued by private companies to get money from investors. These offer higher returns but are riskier as compared to government bonds.
* Unit investment trusts are another type of fixed income investment that are similar to bonds and give good yields.
* Some investments guarantee to your principal irrespective of changes in the index. These are called the principle protected investments.
* Another type of investment is based on real estate, termed the real estate investment trust. This gives steady returns by investing in income generating real estate.
However, investors should carefully consider the terms and conditions of all fixed income investment before investing. Mutual funds in particular do not offer assured returns, so think carefully before investing. Moreover, the returns may vary with change in interest rates. Some issuers may recall the bonds early, so avoid investing in bonds with call options.
As an investor, you must analyze what you want from your fixed income investment, whether you want income or growth. Those seeking a steady income are usually retired individuals. They plan investment in bonds in a ladder-like manner. This implies that some investment matures at periodic intervals and can be reinvested at the prevailing interest rates. This gives a degree of protection against interest rate fluctuations. If rates decline, you are earning a higher rate of interest with your portfolio, and if rates rise, you benefit in your new reinvestments, thus maintaining a steady income from bonds.
If you are seeking growth then you will want capital appreciation in your portfolio. For this you can have a judicious mix of treasury, municipal and mortgage based bonds. You can change the portfolio as per the performance of the Lehman Brother Aggregate bond Index and vary the investment tenure for good returns. This strategy requires active management of your bond portfolio.
In case you are in the higher tax bracket, you may invest in tax-exempt municipal bonds with a higher yield rather than investing in a taxable bond with a very low rate of return. Thus, you must base your investment on your goals and requirements.
You must consider other tax implications on your fixed income investment. Some investments in discounted bonds are subject to capital gains tax. Capital gains are also subject to federal income tax. Municipal bonds are subject to minimum alternative tax.
As an investor, you must understand that bonds help, diversify the risk in your investment portfolio. When held over the long-term they perform better than stocks, with less volatility and assured returns. They provide a steady income stream to meet specific objectives in your life and offer tax benefits to investors. Thus, you must allocate a significant portion of your portfolio to fixed income investments.
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