Fixed-income investments help set a steady rhythm for long-term planning.
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A well-diversified portfolio typically includes fixed-income investments. These are interest-paying instruments such as treasury bonds, corporate bonds, and the certificates of deposit (CDs) you might find on offer at your local bank. When you own a fixed-income investment, you receive a predictable series of interest payments (hence the term âfixed incomeâ).
Fixed income can help preserve wealth and generate a steady source of income as a cushion for your financial future. In general, fixed-income investments are less volatile than the stock market. But theyâre not risk free, and some are more risky than others.
Key Points
- Fixed-income securities are loans to governments, corporations, or banks in exchange for interest paid to the investor.
- Common fixed-income investments include treasury bonds, corporate bonds, municipal bonds, and certificates of deposit.
- When interest rates drop, bond prices rise.
But thatâs the point. Fixed-income investments can help balance out the risk in your portfolio to offset the volatility of, say, a stock market downturn.
Types of fixed-income investments
Although you might be new to the phrase, itâs likely youâve seen (and perhaps invested in) fixed income. Here are some of the more common vehicles:
- Certificates of deposit (CDs). Issued by banks and other financial institutions, most CDs are insured by the FDICâup to $250,000 per accountâmaking CDs among the safest investments available.
- Treasury bills (âT-billsâ). These are short-term government securities with maturities ranging from a few days to a full year, backed by the âfull faith and creditâ of the U.S. government. T-bills are sold at a discount to the face value (or âpar valueâ) and pay a fixed interest rate when they mature. T-bills are considered ultra-safe.
- Treasury notes (âT-notesâ). Treasury notes have somewhat longer maturities of several years up to a decade, with fixed interest rates that pay out every six months.
- Treasury bonds. The maturities for treasury bonds are longer, at 20 to 30 years, with fixed rates that also pay out every six months.
- Municipal bonds. States, cities, counties, and other government entities issue municipal bonds (âmunisâ) to raise funds to build infrastructure, like schools or other public projects. The maturity spans typically range from 2 to 5 years; some may be as long as 30 years. Interest payments from munis are generally exempt from federal taxes, an attractive feature.
- Corporate bonds. When you buy a corporate bond, youâre lending your money to a company, which may use it to develop new products, make a strategic investment, or fund day-to-day operations. Investing in a companyâs debt is more risky than investing in treasury securities or FDIC-insured bank products, so corporate bonds typically pay higher interest rates.
Fixed-income investment example
Say you invest $10,000 in a five-year U.S. Treasury note that pays a fixed interest rate of 4% annually. Every six months, youâll receive $200 in interest payments, totaling $400 a year. After five years, youâll have collected $2,000 in interest, and at maturity, youâll get your original $10,000 back.
This steady stream of income can help offset the ups and downs of the stock market. If the market drops during those five years, your Treasury note continues to pay out, providing stability in your portfolio.
You could also achieve a similar outcome with a certificate of deposit (CD), although your interest payments might compound differently and come with early withdrawal penalties. Or, if you choose a corporate bond instead of a Treasury note, you might receive a higher yield, but with higher risk, since companies can default on their debts.
About that interest rate risk
Bond yields and prices move in opposite directions. When interest rates fall, bond prices riseâand vice versa. Why? Itâs mostly a supply-and-demand story.
Suppose you buy a $1,000 bond paying 4% interest. Regardless of how interest rates move, youâll keep earning that 4% annuallyâassuming the borrower doesnât default. If you hold the bond until maturity, youâll also get your $1,000 principal back.
But if you decide to sell early, your bondâs price depends on current rates. If rates fall to 3%, your 4% bond becomes more attractive, and buyers may pay a premium.
On the flip side, if new bonds pay 5%, yours is less appealing. You might have to sell at a discount to compete with higher-paying alternatives.
Fixed-income default risk and ratings agencies
Default risk: When issuers canât meet their obligations
One of the biggest risks of any fixed-income investment is when the issuer fails to make interest payments or repay the principal at maturity, known as default. This risk varies widely depending on the type of issuer.
To help investors gauge this risk, ratings agencies assess the financial strength of bond issuers and assign credit ratings, similar to how credit bureaus evaluate individuals. Bond ratings range from AAA (or Aaa) for the highest quality to C or D for the riskiest issuers.
Because each agency uses its own proprietary evaluation system, you may see different ratings for the same bond. Itâs wise to check more than one before buying.
The Securities and Exchange Commission (SEC) oversees these agencies to ensure regulatory compliance through its Office of Credit Ratings. Ten agencies were registered as of December 2024, but most bonds are rated by three major ratings agencies:
- Fitch Ratings
- Moodyâs Investors Service
- S&P Global Ratings
Interest rate risk: What happens when rates change
Bond prices move inversely to interest rates. When rates rise, the value of existing bonds typically falls, because new bonds offer better yields. If you sell before maturity, you could take a loss. On the flip side, if rates fall, your bond may gain value because it offers a higher yield than newly issued bonds.
This sensitivity to changes in interest rates is known as interest rate risk. Itâs especially relevant when purchasing bonds in a low-rate environment, since rising rates could erode the value of your bond if you need to sell it before it matures.
If you hold your bond to maturity, however, youâll still receive its stated interest payments, along with your principal, regardless of how interest rates fluctuate.
Inflation risk: When your purchasing power shrinks
Fixed-income investments pay a predictable amount, but over time inflation can erode the value of those payments. If inflation rises faster than the interest your bond pays, your real return may turn negative.
This erosion of purchasing power is known as inflation risk, and itâs particularly important for long-term investors. A bond that yields 3% might seem attractive today, but if inflation climbs to 4%, your earnings lose ground in real terms.
Some investors turn to Treasury Inflation-Protected Securities (TIPS) or other inflation-linked bonds to help offset this risk.
Like all investments, bonds carry an element of risk, and past performance is no guarantee of future results. But most investment professionals recommend dedicating a portion of your portfolio to fixed income to help smooth out the risks associated with stock market volatility and to receive a dependable stream of income.
This article was most recently revised and updated by Jennifer WatersThis article was most recently revised and updated by Doug Ashburn
