The concept of fixed income is enormous and extremely complicated. We will attempt here to give you a quick look at what the concept means, and why it is important to you. If there are any fixed income geeks reading this you may be offended by the simplicity with which we deal with this subject; however, please keep in mind that the intricacies of the yield curve are beyond the scope of this piece.
Many people seek to put some of their investments in fixed income in order to stabilize their returns and generate income. Common types of fixed income investments include bonds and certificates of deposit (CD’s). These investments provide a set income payment and a lump sum payment at the end of the term of the investment. There are varying degrees of risk in these investments, and it is possible that your principal and/or income will not be fully returned to you.
Theoretically, the older you are the more you will tilt your portfolio toward fixed income to increase the income you receive and lower the volatility in your portfolio. This being said, people of all ages often include some fixed income in their portfolios. This is so because fixed income gives you important diversification, and, despite what traditional planning may tell you, being in all equities is almost never a good idea.
Not all fixed income investments carry the same risks, but an important one to consider now is how long you are investing the funds. We are in a period of particularly low interest rates, and thus if you lock your money up for a longer period of time you are taking on risk that you need to be aware of. If you invest in something like a CD, where the principal is guaranteed, then your risk is merely that you will receive a lower interest payment than you otherwise could have by locking in a long term during a low interest environment.
When you invest in bonds the underlying value of that bond fluctuates over its life. If you hold the bond until maturity, and the issuer does not default, then you will get all of your principal back. There are differing levels of risk depending on the issuer of the bond. Generally speaking, the more likely the issuer will default the higher the yield the issuer will have to pay.
Mutual funds can be a great way to diversify your holdings; however, fixed income mutual funds can have some inherent risks built into them. With an individual bond, if you are confident the issuer will not default, then you are free to hold it until maturity and not really risk any losses. While the value of the bond will fluctuate, you will still get the same stream of income and then all of your principal back when it matures. Thus what happens to the “value” in between is less important. With a mutual fund the fluctuation in value is more of a risk to you, as you do not have control over whether or not these bonds are kept to maturity. The bond fund manager does not even have complete control over this, as he may be forced to sell at an inopportune time to meet redemptions if too many of your fellow investors decide to cash out.
Many people take a hands off approach to their investments and employ a set asset allocation. This can be problematic in a fixed income environment such as the present one where rates are as low as they can be. Eventually rates will have to go up. Thus, the portion of an allocation dedicated to intermediate to longer term fixed income will hurt when rates go up.
Actively changing your allocation is not always a good idea if you are not confident in your ability to react to changing market events on a regular basis. At the same time it is hard to watch something you know will lose value. At this time, our best advice is to stay short with your fixed income investments. Make sure that you do not have things that will mature past about two years. Generally speaking, intermediate bond funds can add strong diversification to your portfolio, but in the near term they are likely to just lose money for you.