Should I invest in a fixed-income security? Pros, cons & risks
Bonds, CDs, and money markets--all of these investments, which you may have heard of, are types of fixed-income securities. But what is a fixed-income security, and is it right for you?
Fixed-income securities pay a fixed amount of income several times over a certain period, eventually returning the principal when they mature. They differ from variable-income investments, where the interest rate or other factors affecting income from the investment change over time. In other words, you know on the day you make it how much money a fixed-income security is going to accrue.
Most fixed-income securities pay out via semi-annual coupon payments until they mature. This is how government savings bonds work. Bonds, the most frequently-issued type of security, allow organisations--like government institutions or corporations--to raise capital. It’s basically a loan they take out from you, the consumer, which is eventually repaid with interest.
Every bond is given a credit rating, which will reflect how the institution issuing the bond is doing financially. This tells you, the investor, how risky your investment is, because it’s essentially a rating of how likely the issuer is to repay the loan. Those with the lowest risk of default are known as investment-grade bonds. While bonds with lower credit ratings may promise higher interest payments, they also come with a higher probability that you won’t get your money back. For some, the higher payments will compensate for the risk, but others will want the best bet for their buck.
Government and corporate bonds aren’t the only option when it comes to fixed-income securities. Municipal bonds may be issued to fund local projects that require a capital investment, like a new bridge or hospital. Many of these are tax-exempt.
A certificate of deposit (CD) from a bank, in exchange for saving with them for a certain amount of time (usually less than five years), is another way to earn fixed interest, although the payments will be lower than with most bonds. On the other hand, CDs are usually more lucrative than a traditional savings account.
While the value of a security may change if you sell it before it matures, the likelihood of the principal being returned is unlikely to change. Bonds are great for those who want to invest without being affected much by the volatility of the market, or for those who want to offset the risk of less stable investments, like stocks. If you’re considering one, you can go through a broker, mutual fund, or ETF to get started.