Investing In Fixed-Income Securities
Fixed-Income Investments Defined
There are a number of fixed income securities, which are usually thought of as investments that pay a certain level of income within a certain period of time. Without detailing every conceivable type of fixed income security, the basics include:
- Treasury Bonds, Treasury Bills, and Treasury Notes
- Zero Coupon Bonds
- Corporate Bonds
- Certificate of Deposits
- Savings or Money Market Accounts
Government obligations are usually thought of United State Government, and they can include (1) Treasury Bonds, (2) Treasury Bills, and (3) Treasury Notes. The federal government has a need to raise money to be able to perform the tasks it is authorized to do, and as such, it offers the opportunity to investors to "loan it money." Investors do this by buying these government instruments, with the knowledge that the government will either (1) pay money during the "loan" for the use of the money; or (2) pay extra money at redemption for the use of the money; or (3) both.
Treasury Bonds are those bonds that mature in 10 years, pay interest at a specified rate two times per year, and may be [but not always] callable after five (5) years at the par value, which is set by the bond at the time of its purchase. The benefit of Treasury Bonds, is that many are not callable, and if interest rates tend to fluctuate, other bonds may be called, leaving the investor in a position with no investment, just when the investor can benefit the most.
Treasury Bills are bought by the investor at a discount rate from the face value of the Bill, and redeemed at full face value when the period of maturity ends. These Bills are usually in the amount of $10,000, but others can be for differing amounts.
Treasury Notes are interest paying, and are issued, like Treasury Bonds, at or near par value. They have varying dates of maturity, depending upon the preference of the investor.
Savings Bonds are also government issued and fall into certain types. The benefit is that they are not callable, but on the down side, they are also not transferable, and are not acceptable as collateral for loans, which may or may not be important to an investor.
Zero Coupon Bonds
These are special bonds sold without any expectation of the payment of interest to the investor over the life of the coupon. They are often sold at a discount over their par value payable at maturity. The benefit of these "zeros" is that they lock in current interest rates for the duration of the bond, and thus, enable investors to take advantage of high interest rates, when the investor's expectation is that interest rates will decrease over time.
Corporate or Municipal Bonds
Corporate Bonds are "loans" to a company, in return for its promise to pay the investor back a stated rate of interest, which may not always be the same rate throughout the bond (it may "float"), and to repay the entire "loan" amount at the maturity date. Unlike some Government Bonds, these can be "called" by the company, as specified, and the company will usually do this when the interest rates being paid on the bonds become out of line with market interest rates. This happened recently when interest rates began to fall markedly to 6 and 7 percent from 12 and 11 percent in the period just before the fall.
Interestingly, because the falling interest rates created much investor unhappiness, when their high-interest paying bonds were redeemed, many corporations now issue bonds with noncallable provisions or with some limitations. Without these, many investors will no longer purchase these bonds, and the corporations lose the revenue otherwise available to them through this source of loans.
Municipal Bonds are exempt from federal income tax, and many state and local income taxes. (However, there is a possibility that the alternative minimum tax may alter this tax-exempt status for some individuals and they ought to verify the applicability of this tax to their particular situation.) Be sure to check your locality and state for current municipal bond exempt status. Also, be sure to check that there are no other taxes that can be levied by your state or locality.
The types of Municipal Bonds varies and we do not have enough space to provide a detailed explanation of each. There are plenty of books dedicated to the topic of Municipal Bonds, if you are interested. The basic kind are backed by the municipality’s credit rating, which can vary by municipality, and they pay a defined stream of interest to investors during the period of the bond. The bond is usually repaid from taxing entities that have been authorized by voters to issue and then repay at maturity the bonds. These interest rates and maturity dates, as well as face value, are all in varied amounts, for maximum flexibility to the investor.
The investor should look for either the higher credit ratings for municipalities in selecting bonds, or look for bonds with insurance to cover certain investor losses, in these unlikely events.
Certificates of Deposit
When interest rates were historically higher than they have been in the 1990's, bank issued Certificates of Deposit were the security of choice for many older Americans. These Certificates of Deposit are lump-sum payments to Banks, in return for the monthly/quarterly payment of a specified interest rate, regardless of what the interest rate market or the economy experienced. At the end of the maturity period, which usually lasted from one month to five years, depending upon the investor’s choice (with the interest rate being higher for the longer periods of time an investor allowed the bank to use its funds), the Bank would either pay the money back to the investor, or "roll-over" the CD into another CD, paying the Bank's market interest rate at the time.
When interest rates were not moving lower each quarter, or were not moving around significantly, investors did not have to pay much attention to these investments, and they are FDIC insured (up to $100,000). Currently, the rates being paid on long-term CDs are still considerably less than the "right" investments in the stock market. During the period of 1995 to 1998, for example, CD rates averaged less than 6% per year, while the average returns in the stock market were closer to 25%, or much higher in some cases. All of a sudden, many investors realized that their "stomach" for more risk was agreeable, and much CD money left the Banks for Mutual Funds and stock portfolios. Needless to say, these economic conditions will not always be present, and CDs will likely be an attractive investment choice, at that time.
Savings Accounts or Money Markets
Perhaps the best flexibility for the investor, since the money can come and go as necessary, it is exactly for this reason that these investments pay the lowest rates of interest. Many people still utilize these accounts because of their flexibility and safety, but to any long-term investor, this is no way to build wealth. A financial planner can help a person to understand how dangerous to the financial health, and any accumulation of money goal, such accounts may be.
While these are not fixed income investments exactly, they function more like fixed-income assets that the other investment types we have discussed. Annuities are part insurance and part investment, and do not always make sense for many investors. Additionally, many annuities pay high rates of commission income to those, such as banks or insurance agents, or some financial planners, who sell annuities. Also, annuities typically have above average operating and management costs and fees, and your lump-sum payment may be depleted by these fees, leaving less money to "work for you."
However, if properly understood and evaluated, annuities can be of some help to investors, usually when investors have accumulated all of the money in their retirement accounts that they are allowed by law.
Many financial planners do not recommend that you purchase annuities inside retirement accounts, although the purchase of them outside retirement accounts may, in some cases, be justified. If a financial planner cannot wait to sell you an annuity, this may be a sign that their interest has diverted from your interest because of a high commission promised to them for selling the annuity.
Hybrid and Other Fixed-Income Securities
There is a host of other hybrid and specialty type fixed-income investments. Any financial planner can discuss the particular nuances of any of these with you, and books and resources abound with explanation of the next "can't miss" investment. Fixed-income securities, however, will almost always have a more conservative investment nature, and may not always be the best vehicle for wealth-building, if that is your goal. Each investor must decide these issues for themselves.
Investing In Fixed-Income Securities