Fixed income is an investment that provides a steady stream of cash flows. Common examples include defined-benefit pensions, bonds, and loans. Fixed income also includes certificates of deposit, savings accounts, money market funds, and fixed-rate annuities. You can invest in fixed income securities via bond mutual funds, exchange-traded funds (ETFs), and fixed income derivatives.
Types of Fixed Income
There are four broad categories of fixed income investments. Short-term products return a low rate, but you only tie up your money for a few months at most. Long-term products pay a higher rate, but you must leave your money invested for years.
The interest rates on short-term fixed-income accounts are reflective of the fed funds rate. When the fed funds rate was lowered to zero in 2008, these products earned super-low interest rates. To gain a higher yield, many individual investors shifted from short-term to longer-term investments. Businesses use short-term loans to cover the cash flow needed to pay for day-to-day operations.
- Savings Accounts: The bank pays you a fixed rate of interest, based on the fed funds rate. You can add or withdraw whenever you like.
- Money Market Accounts: The bank pays you a slightly higher fixed rate of interest. In return, you must keep a minimum amount deposited. You are limited in the number of transactions you can make in a year.
- Certificates of Deposit: You must keep your money invested for an agreed-upon period to get the promised rate of return.
- Money Market Funds: These are mutual funds that invest in a variety of short-term investments. You get paid a fixed rate based on short-term securities. These included Treasury bills, federal agency notes, and Eurodollar deposits. They also included repurchase agreements, certificates of deposit, and corporate commercial paper. They are also based on obligations of states, cities, or other types of municipal agencies.
- Short-term Bond Funds: These mutual funds invest in one-year to four-year bonds, largely, investment grade corporate bonds.
Long-term fixed-income investments is called a bond. This type of instrument reflects a debt arrangement between a corporate or government issuer and an investor (creditor). For corporate issues, the interest rates offered depend on Treasury rates as well as the credit risk and duration risk associated with the issue.
Investment grade bonds are generally considered stable investments. For this reason, they typically offer lower returns than higher-risk assets, such as stocks. Historically, bond prices have exhibited minimal correlation to stock prices, even negative correlation during recessionary periods. However, this has changed in recent years, as the two asset classes have exhibited a much higher degree of correlation.
Here are the different types of bonds.
- Government bonds are the safest because they are guaranteed. Since they're the safest, they offer the lowest return. U.S. Treasury notes and bonds are the most popular, with $16.6 trillion outstanding in 2019. Savings bonds are also guaranteed by the U.S. Treasury. They are designed for smaller investors. Municipal bonds, at $3.8 trillion outstanding, are sold by cities, states, and other municipalities.
- Corporate bonds offer a higher rate. Companies sell them when they need cash but don't want to issue stocks. There are currently $8.1 trillion in these bonds outstanding.
- There are two hybrids of corporate bonds and stocks. Preferred stocks pay a regular dividend, even though they are a type of stock. Convertible bonds are bonds that can be converted to stocks. Stocks that pay regular dividends are often substituted for fixed-income bonds. Although they are not technically fixed income, portfolio managers often treat them as such.
- Eurobonds is the common name for Eurodollar bonds. These are international bonds denominated in a currency other than that of the domestic currency of the market in which they are issued. An example is a European company issuing bonds in Japan, which are denominated in U.S. dollars.
- Bond mutual funds are mutual funds that own a large number of bonds. That allows the individual investor to gain the benefits of owning bonds without the hassle of buying and selling them. Mutual funds grant greater diversification than most investors could obtain on their own.
- Exchange-traded funds (ETFs) track the performance of a bond index. They aren't actively managed like a mutual fund. Bond ETFs are popular because they have low costs.
Fixed Income Derivatives
There are many financial derivatives that base their value on fixed income products. They have the most potential return because you invest less of your money. But if they lose money, you could lose much more than your initial investment. Sophisticated investors, companies, and financial firms use them to hedge against losses.
- Options give a buyer the right, but not the obligation, to trade a bond at a certain price on an agreed-upon future date. The right to buy a bond is called a call option. The right to sell a bond is the put option. They are traded on a regulated exchange.
- Futures contracts are like options, except they bind participants to execute the trade. They are traded on an exchange.
- Forward contracts are like futures contracts, except they are not traded on an exchange. Instead, they are traded Over the Counter (OTC), either between the two parties directly or through a bank. They are often very customized to the particular needs of the two parties.
- Mortgage-backed securities (MBS) derive their value from bundles of home loans. Like a bond, they offer a rate of return based on Treasury rates as well as the risks specific to the underlying assets.
- Collateralized debt obligations (CDO) derive their value from a variety of underlying assets, including corporate bank loans, auto loans, and credit card debt.
- Asset-backed commercial paper are one-year corporate bond packages. They are based on underlying commercial assets. These include real estate, corporate auto fleets, or other business property.
- Interest rate swaps are contracts that allow investors to swap their future interest rate payments (or receipts). Oftentimes, this arrangement involves a payer (or receiver) of a fixed-rate stream of interest bond and a payer (or receiver) of a floating-rate stream of interest. They trade OTC. Swaptions are options on an underlying interest rate swap – a derivative based on a derivative. Generally, swaps and swaptions should be used for hedging purposed by sophisticated investors; they should not be used by inexperienced investors looking to speculate on interest rate movements.
- Total return swaps are like interest rate swaps, except they involve the exchange of cash flows associated with one asset and another tied to a benchmark or index (such as the S&P 500).
Third-Party Fixed Income Payment Streams
Some fixed income streams don't depend on the value of an investment. Instead, the payment is guaranteed by a third party.
Fixed payments available after a certain age. It's guaranteed by the federal government and is calculated based on payroll taxes you've paid. It's managed by the Social Security Trust Fund.
Fixed payments guaranteed by your employer, based on the number of years you worked and your salary. Companies, unions, and governments use pension funds to make sure there's enough to make the payments. As more workers retire, fewer companies are offering this benefit.
Fixed-rate annuities are an insurance product that guarantees you a fixed payment over an agreed-upon period. These are increasing since fewer workers receive pensions. One variation of this product that can provide some long-term upside is a variable annuity. In certain cases, it can offer an agreed-upon fixed payout stream, which is underwritten based on a basket of equities funded with your initial contribution. The basket of equities can increase the value of the annuity in the event of a major increase in the equity market, but still provide a base level fixed income.
How Fixed Income Affects the U.S. Economy
Fixed income provides most of the liquidity that keeps the U.S. economy humming. Businesses go to bond markets to raise funds to grow (for shorter term needs, they use the money markets, which are also comprised of very near-term fixed-income securities). They use money market instruments to get the cash needed for day-to-day operations.
Treasury bills, notes, and bonds serve as benchmarks for other interest rates. When demand for Treasury debt declines, yields rise. Investors then demand higher interest rates on other, fixed-income products. This sends rates higher for everything from auto loans to school loans to home mortgages.
Low-interest rates could trigger inflation. That's because there's too much liquidity chasing too few goods. If inflation doesn't show up in consumer spending, it might create asset bubbles in investments.
In some situations, Treasury yields can be used to forecast future economic conditions. For example, an inverted yield curve (short-term rates higher than long-term rates) often heralds a recession, which could then lead to rapidly declining short-term rates (Fed induced) and persistently low long-term rates—until an economic recovery and signs of inflation begin to emerge. When rates are lowered, other interest rates in the economy fall too, such as mortgage interest rates. This, in turn, affects the demand for real estate. Thus, interest rate changes can ripple through the economy and affect consumer prices.
The Value of a Dollar
The demand for Treasury debt is a major factor that influences the value of the dollar. That's because Treasury debt is denominated in U.S. dollars. Incidentally, as a safe-haven investment, it is coveted by risk-averse investors domestically and abroad, especially during volatile times. This was apparent in the wake of the 2008 recession, when the Federal Reserve's expansionary monetary policy, which included an unprecedented degree of quantitative easing, caused a surge in demand for Treasuries and other high-quality debt instruments.