- Understanding fixed income investments
- What is a fixed income investment?
- How do fixed income investments work?
- Types of fixed income
- Duration vs. term
- Bond coupons vs. yields
- Benefits of fixed income investments
- Fixed income risks and limitations
- Fixed income pros and cons
- How to invest in fixed income
- FAQ: Fixed income investments
Understanding fixed income investments
Stock markets talk a big game, but when it comes to attracting total investment dollars, the fixed income market has equities beat. The fixed income, or debt, market is a deep and liquid market that’s US$2 trillion larger than the global equity market.1 A significant portion of that market is made up of bonds, which have a reputation for being pretty staid, at least compared to stocks, which can see sharp advances and declines when investor sentiment changes. For investors, fixed income has long been a critical component of a balanced portfolio, partly because it’s less volatile than stocks. If you are looking for secure and steady returns, you may want to familiarize yourself with this asset class.
What is a fixed income investment?
Fixed income refers to publicly traded debt investments such as bonds, money-market securities, debentures and preferred shares. Governments and companies that need to raise money issue debt instruments with the understanding that they will repay investors the full amount of the loan principal at a set maturity date, plus the stated interest. Basically, they are IOUs.
How do fixed income investments work?
Generally speaking, issuers promise to pay the investor interest at regular intervals for as long as they hold the security — hence the term “fixed income.” But because they are tradable, the value of these investments can still go up or down depending on market conditions, the term to maturity, the interest rate and the creditworthiness of the issuer.
Because holding individual bonds and other debt investments involves keeping track of maturities, many small investors own funds that hold bonds instead. This way they get diversified exposure to the fixed income market in a liquid, income-generating investment that is perpetually reinvested. Just know, fund companies charge management fees that are subtracted from returns.
Types of fixed income
Government bonds are issued by governments and are considered the safest debt instruments because governments have the power to raise taxes and almost never become insolvent. The bigger the government, the safer the bond (usually). The safest of them all are Treasury bills (a.k.a. T-bills or treasuries) — short-term debt issued by federal governments in Canada and the United States. T-bills don’t pay interest like other fixed income investments, instead they are sold at a discount to their par or face value and the government agrees to pay you the full value when it matures.
Corporate bonds are typically considered to be riskier than government bonds because there is always the chance that a company could go bankrupt. Investment-grade corporate bonds are typically safer than high-yield bonds — sometimes referred to as junk bonds — but the latter pay higher interest rates.
Money market securities are very short-term debt instruments that mature in less than a year. Since they are typically traded solely among financial institutions, retail investor access is usually limited to money market funds. They tend to be low risk, with low yields to match.
Preferred shares are a kind of medium-risk hybrid between bonds and stocks. They represent equity in the company but pay a set yield, which may be linked to prevailing interest rates. If the company becomes insolvent, preferred shareholders get paid after bondholders and other creditors, but ahead of common shareholders.
Duration vs. term
There is a lot of jargon to understand when you’re an investor and the world of fixed income is no exception. While this language can make investing intimidating, you can take some comfort knowing that the concepts behind the words are not overly complicated. Bond duration and bond terms are two good examples:
Bond duration is really just a way of measuring how many years it will take you to recoup your initial investment in the bond, factoring in any interest you earn along the way. It’s generally seen as a way of understanding how sensitive the bond is to changes in interest rates.
Bond term on the other hand is a measure of how much time remains until principal repayment is due, which does not change with interest rates. You’ll also hear this described as “term to maturity.” Short-term bonds mature in five years or less while long-term bonds can be held for up to 30 years.
Bond coupons vs. yields
When you hear the term coupon, you may think about saving money at the grocery store, but coupons in the context of fixed income investing work a little differently. A coupon, or coupon yield, is the annual interest rate that was set by the issuer when the bond was issued. This figure remains constant for the life of the bond.
Yield or current yield is another term you’ll often hear when investing in fixed income. The yield or current yield can fluctuate over time. In simple terms, it’s calculated by dividing the coupon amount by the current price. If the price of the bond falls, say in response to falling demand, the yield will rise. Investors look at the yield as the actual return they would get from a bond from the time they had purchased it through to maturity.
Benefits of fixed income investments
Fixed income has three main benefits for investors:
- The large and liquid fixed income market tends to be less volatile than equity markets, giving investors a less risky way to invest.
- It generates a reliable income stream for people who need it, like retirees.
- It provides diversification benefits to a balanced investment portfolio. Fixed income investments have a generally negative correlation to equity investments, which is to say, when stock markets decline, bonds typically gain value. By holding both, you may reduce the risk of losing money.
Fixed income risks and limitations
Fixed income can fare poorly when interest rates rise, as witnessed in 2022 when the FTSE Canada Bond Universe Index declined by 11.7%. Nobody wants to buy an old bond paying 1.5% a year in interest when new ones are available that pay 3.5%.
When bond rates are low, as they were for most of 2010-2020, they provide very little income yield. Some fixed income investments come with a higher yield, but this is offset by the higher risk.
Individual bonds and some preferred shares also come with maturity dates, which can make them inconvenient to hold. When a bond reaches maturity, holders have to reinvest. Investors can get around this by holding bond mutual funds or Exchange-Traded Funds (ETFs) instead. Some investors prefer to hold individual bonds. By holding a bond to maturity, they can avoid the risk of capital losses that may occur as a result of trades made within the mutual fund or ETF.
Fixed income pros and cons
Pros:
- Lower risk, and typically less volatile than equities. Fixed income investments can help to ensure capital preservation.
- Generates a steady income stream.
- Returns not correlated to stocks.
Cons:
- Lower long-term returns. Over periods of 10 years or more, fixed income will almost always earn you less money than equities.
Ultimately, the choice between the two is not a binary decision. Most investors hold both fixed income and equities. As their needs change — for example, as the investor approaches retirement — they may consider shifting to a more conservative portfolio by adding fixed income and reducing their exposure to stocks.
The risk that inflation will outpace the yield on a fixed income investment creates the possibility that your real return could be below inflation.
How to invest in fixed income
There are multiple ways to invest in fixed income. You can:
- Open a brokerage account. With a TD Direct Investing account, you can buy and hold individual bonds and preferred shares, fixed-income ETFs or mutual funds.
- Open an account with a mutual fund dealer and purchase fixed income mutual funds.
- Open an account with an automated investment advisor that could create a portfolio matched to your goals, time horizon and risk tolerance. It will almost certainly include a fixed income component.
Your choice of service will partially depend on your investment knowledge and service needs. Advisory services usually involve higher fees than a do-it-yourself online brokerage account.
FAQ: Fixed income investments
Are ETFs fixed income?
Not necessarily. ETFs are funds that trade on a stock exchange like stocks. They can be invested in a variety of underlying asset classes, including fixed income and equities.
What is a fixed income mutual fund?
A fixed income mutual fund is a pooled fund invested in fixed income securities such as bonds, money market securities, mortgages and preferred shares. You buy them from an investment dealer/advisor or directly from the fund company.
Do you pay taxes on fixed income?
Interest income from bonds, preferred shares or fixed income funds held in a non-registered account is taxable on an annual basis, and you may have to pay capital gains tax when you sell these assets if they increased in value. Income from bonds is considered interest and taxed at your top marginal rate while preferred shares produce dividends, which are taxed more favourably.
You don’t have to report income or pay taxes on fixed income investments as long as they are held in a registered account such as a Registered Retirement Savings Plan (RRSP), Tax-Free Savings Account (TFSA) or First Home Savings Account (FHSA).
What is the difference between fixed income and equity securities?
Equity securities (stocks) represent an ownership share in a company, whereas fixed income is essentially a loan agreement. Stock values change continuously, reflecting changes in the company’s profit outlook. By contrast, the value of fixed income securities is ultimately tied to both the fixed interest payments and the return of the principal at maturity. The market price of fixed income securities, whether held individually or in a fund, therefore tends to be more stable than that of equities.
- “Capital Markets Factbook, 2022,” Securities Industry and Financial Market Association, July 12, 2022, https://www.sifma.org/resources/research/fact-book/ ↩