Welcome to a new series here on Macro Mondays: investing in fixed income securities. While equities (stocks) are very attractive, fixed income securities are essential to preserving returns and minimizing risk over the long run. Investing well involves consistently balancing equities and fixed income and adjusting the weights more to the fixed income side before retirement.
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Fixed-income securities are investments that generate fixed returns in the form of interest payments to investors, and the eventual return of principal at maturity. Unlike variable-income securities – where returns change based on underlying factors such as short-term interest rates or the growth of the issuing company - fixed-income security payments are always known in advance.
The most common type of fixed-income security is a bond. A bond is essentially an IOU issued by a federal government, local municipality or corporation to finance projects or activities. When you buy a bond, you’re extending a loan to the bond issuer for a specific amount of time. In exchange for the loan, the issuer pays you a specified interest rate – known as the coupon rate – at regular intervals until the bond reaches maturity. In general, the higher the coupon rate, the higher the risk. When the bond matures, the issuer repays the loan and you receive the full face value, or par value, of the bond.
For example, if you buy a bond that has a face value of $1,000, a 5% coupon and a maturity of 10 years, you’ll receive a fixed $50 in interest each year for the next 10 years ($1,000 * 5%). When the bond matures in 10 years, you’ll be paid the bond’s face value – $1000 in this example.
CDs and Preferred Stocks
While bonds are the most common fixed-income security, there are other types, including certificates of deposit (CDs), which pay regular interest, and preferred stocks – where payments are made in the form of fixed dividends. With all fixed-income securities, the investor knows exactly how much income they’ll earn from the security.
Of course, all this certainty comes at a price: Fixed-income securities generally have a lower rate of return than variable-income securities and many other investments. As such, fixed-income securities are especially popular for risk-adverse investors, but they also play an important role in asset allocation – balancing the risk and reward in an investment portfolio.
A widely-accepted rule of thumb suggests maintaining a portfolio of stocks and bonds (plus other fixed-income securities and cash), where the percentage of stocks is equal to the number 100, less your age. For example, if you’re 40 years old, your ideal asset allocation would be 60% stocks (100 – 40) and 40% fixed-income and cash.
Because of today’s longer life spans and the general lack of savings for retirement, many financial advisors now recommend starting with the number 110 or even 120 before subtracting your age to get the ideal stock percentage for your portfolio. That keeps your money in the stock market longer, so you’ll have a better chance of being financially prepared throughout retirement.
As with any type of investments, if you’re interested in trading fixed-income securities, it pays to do your homework and learn as much as you can – before you start trading. To help you get started, this tutorial introduces the basic structure of the fixed-income market, as well as the process for and mechanics of trading fixed-income securities.