Fixed Income Portfolio
Asset portfolios that comprise fixed-income securities.
What is a Fixed Income Portfolio?
As the name suggests, fixed-income portfolios are those kinds of asset portfolios that comprise fixed-income securities, often referred to as debt securities. These securities pay the investor a fixed interest or coupon until the security reaches maturity.
Along with the interest payment at regular intervals, the investor is bound to receive the principal amount in full at the end of the maturity duration of the fixed-income security.
Equity instruments are not expected to pay any money to the investor or, at times, might declare a dividend or an interest payment depending upon the economic cycles and performance of the business.
However, there are no such criteria for fixed-income securities. The borrower must repay the interest money at regular intervals and is also expected to repay the full principal amount upon maturity, regardless of the market cycles.
Like equities, which can be bought individually or through a managed investment fund, fixed-income securities can also be purchased individually by investors or through a pool of funds referred to as debt or exchange-traded funds.
In the event of liquidation, fixed-income security holders have a higher claim over the company’s assets, which implies that the debt holders will be paid first before repaying the company’s equity shareholders.
Some of the most common forms of fixed-income securities are corporate and government bonds, treasury bills and notes, certificates of deposit (COD), and bond mutual funds.
Types of Fixed-Income Securities
Different types of fixed-income securities are available to investors in the financial market. Various types of debt instruments are explained as follows:
1. Government Bonds
These securities are the bonds issued by the state and federal government and are one of the safest forms of investment as these bonds are backed by the credit rating of the country’s government.
The government generally issues government bonds with financing local expenditures in the country, which generally carry a maturity duration of 10-30 years. Holders of these bonds are often entitled to tax-free benefits.
2. Corporate Bonds
These are the bonds issued by large corporates, and the prices and interest rates of these bonds depend on the issuer’s financial stability and creditworthiness.
Bonds with higher credit ratings mean the sound creditworthiness of the issuer. This implies a lower default risk for the investor, so the coupon payments on these bonds are lower.
3. Treasury Bills and Notes
Treasury bills are short-term debt securities that tend to mature in less than a year. Therefore, these securities do not pay coupon payments to the investor.
The difference between the discounted purchase price and the selling price at par creates an income for the investor.
On the other hand, treasury notes mature within 2-10 years, pay fixed interest rates at equal intervals, and these notes are sold at multiples of $100.
4. Certificate of Deposits (COD)
A certificate of deposit is a medium to long-term fixed-income instrument issued by financial institutions like banks for a maturity duration of 2-5 years.
These instruments’ interest rate is generally higher than the interest rate for savings accounts and is backed by protection from the National Credit Union Administration (NCUA).
Fixed Income Investing Strategies – Types
The different types of investing strategies that investors can adopt while investing in debt securities to maximize their returns are as follows:
1. Laddered Bond Portfolio Investing
This investing strategy is mainly concerned with diversifying the asset portfolio by purchasing different debt securities with different maturity durations in the form of a ladder’s step.
Portfolio diversification will help the investor to mitigate the risk and benefit from the short-term bonds by reinvesting the returned principal into higher-rung bonds. This will also enable the investor to generate higher returns.
This strategy is also known as bond ladder investing.
2. Bullet Investing
The main idea behind this strategy is to purchase debt instruments at different calendar dates, but both instruments should mature on the same date. A portfolio is thus constructed with a mix of such securities.
This will help to diversify the portfolio and also helps to ensure a bullet of profitable returns in the future at the maturity date. Moreover, this strategy is most suited to investors who want a huge sum of money in the future.
Also referred to as the bullet bond investing strategy, this method can be useful if the investor wants to finance a big expenditure in the future, such as a child’s college education, wedding expenses, or medical expenses.
3. Barbell Portfolio Investing
This fixed-income strategy aims to prepare a portfolio with two extremes, i.e., short-term and long-term bonds, without any intermediate bonds on the portfolio.
Also known as the barbell bond portfolio investing strategy, the main idea behind this strategy is to keep an eye out on the short-term bonds and thereby keep rolling them into new issues as they mature over time.
Short-term bonds in these portfolios mature within five years, whereas long-term bonds mature in 10 years or more, and this strategy requires active portfolio management so that the rolling of short-term bonds can be done efficiently.
Features of Fixed-Income Securities
The characteristics of fixed-income securities are explained as follows:
1. Regular Income Stream
Fixed-income instruments like bonds and treasury bills provide periodic payments to the investor through interest or dividend payments. These payments can be received monthly, quarterly, or yearly.
These investment options are extremely popular among those investors who aim to receive a regular income from their investment. As a result, these securities help diversify the portfolio risk and entitle the investor to a stable income flow.
2. High-Interest Payments
Interest rates on fixed-income securities (3.5-4%) are typically higher than the interest rates offered on savings account deposits.
This higher interest rate offered on the security attracts the investor to invest in these securities rather than depositing the funds in a savings account, as these securities will generate a higher return for the investor.
3. Tax Benefits
Income streams such as interest payments or dividends received by holders of fixed-income instruments are considered to provide taxable benefits to the investor as the income is tax-free in the hands of the investor.
Although the companies are expected to pay a distribution tax while distributing dividends or interest, the investors are exempt from paying taxes on them again to avoid double taxation.
4. Low Risk-Return Relationship
Risk-averse investors generally favor these kinds of securities as these securities tend to be less risky and are considered safe forms of investment. This means that these securities bear the low risk and low returns.
Investors also use fixed-income instruments to diversify the portfolio risk as these securities reduce the high risk of the portfolio, thereby generating maximum return at the lowest possible risk.
Fixed Income Securities – Benefits
The advantages of investing funds in fixed-income securities are explained as follows:
1. Portfolio Diversification
Fixed-income instruments are very popular among investors as these securities, along with other securities, tend to increase the portfolio’s overall return at the minimum possible risk.
Along with other securities tend to increase the overall return of the portfolio at the minimum possible risk.
Since these securities have a low correlation coefficient with equity instruments, frequent fluctuations in the stock exchange do not significantly affect the price of these securities.
2. Low-Risk Securities
Fixed-income instruments are considered to be safer forms of investment and are less risky than equity securities. Returns of debt securities are fixed against a benchmark interest rate, and the earnings are not volatile.
Due to the regular flow of income, these securities are most preferred by risk-averse investors.
Moreover, the risk of these instruments is based on the credit rating of the issuing firm. Therefore, investors can choose the best possible security.
3. Higher Claim over Assets
Since fixed-income securities are regarded as debt instruments, holders of these securities have a higher claim over a company’s assets than equity shareholders.
This means that upon the event of liquidation, it will be the debt security holders that will be paid first. After all the funds are used to repay debts, the remaining money will belong to the equity shareholders of the organization.
4. Stable source of income
Debt securities tend to provide a stable source of income to the investor, as holders of these securities are expected to periodically receive income in the form of dividends or interest payments.
Thus, these securities are very useful for old investors because the timing of cash inflows is known beforehand, enabling them to plan their future budgets accordingly.
Fixed Income Securities – Drawbacks
The disadvantages of investing in fixed-income securities can be explained as follows:
1. Possible Credit and Default Risk
The investor needs to understand the bonds’ credit rating as these ratings determine the issuer’s creditworthiness.
Bonds with credit rating BBB and beyond are considered risky and often termed junk bonds. A corporation’s credit risk can negatively affect the valuation of fixed-income securities.
The prices of bonds are expected to fluctuate up and down until the bond reaches its maturity. Due to price fluctuations, it is never guaranteed that the investor to receive the total amount, thereby increasing the possible credit and default risk.
Interest rate risk is one of the possible risks that a fixed-income investor comes across while holding a bond. This is because interest rates frequently fluctuate, and the changes in interest rates tend to impact the valuation of the bond.
Due to the negative correlation between the interest rate and bond valuations, an increase in the interest rates will lead to a decrease in the bond prices, and vice versa.
3. Inflationary Pressures
An increase in inflationary pressures significantly affects the income which the bondholders receive. As a result, an increase in inflation rates significantly impacts the returns generated for fixed-income security holders.
For example, a bondholder who earns a return of 2% faces an inflationary pressure of 1.5%. This will lead to a loss of income for the investor as he/she will only be able to earn a real return of 0.5%.
4. Lower Rate of Returns
Unlike equity instruments, fixed-income securities are much safer, and as a result, they generate lower rates of return for the investor.
Due to the lower yield, these securities do not offer an aspect of growth in the investment, and the investor is only bound to earn the periodic interest as an income.
Conclusion
Fixed-income securities are, therefore, those kinds of financial instruments that tend to pay a fixed rate of return to the investor in the form of periodic interest payments or dividend payments. Along with the interest payments, the investor receives the principal amount upon maturity.
These assets are completely different from equity securities as debt securities are considered to be less volatile and are considered to be safer financial instruments than equity shares.
Bonds are not subject to as many fluctuations as equity shares experience; thus, the bonds pay a very minimal rate of return. Moreover, paying dividends or coupons to the investor at regular intervals is not compulsory. Instead, that is done at the convenience of the company.
A well-diversified asset portfolio should always be constructed with a certain level of weightage provided to fixed-income securities to offset the high risk generated from equity assets and other alternative asset classes like real estate and private equity.
Including debt securities like bonds and certificates of deposit helps to reduce a portfolio’s overall risk and thereby create a diversified portfolio that aims to provide the maximum possible return at the lowest possible risk.
However, one should never perceive these securities as completely risk-free as they are always subject to certain pressures from economic factors like inflation and interest rates.
Thus, it is always advised to use these securities as wisely and efficiently as possible to lower the risk factor and maximize the return for my investor.
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