When people talk about investing, stocks usually get the most attention. However, investments can also be made in a whole range of other assets. Cryptocurrencies and alternative assets are two more widely debated investments. Still, fixed-income securities are the backbone of many pension pots. Yet, they are so rarely discussed. That is to their detriment because they can be a handy tool in a portfolio for many reasons. Plus, if effectively invested in, they can provide some highly beneficial earnings to bondholders or people with other types of fixed-income investments.
But fixed-income investments are a broad asset range in themselves. So what fixed-income investments offer the best returns?
What is a fixed-income security?
Before delving into what fixed-income investments offer the best returns, let's get the basics right, right from the start. It is crucial with every investment to fully understand it and all its nuances. Which is easier said than done with fixed-income investments. They have many complicated elements due to how they move in relation to macroeconomic factors, their interest rates vs price, and other market risks to which they are sensitive.
However, on a basic level, a fixed income investment is one where you loan an entity money, and they give you back that loan after a predetermined number of years with interest. How that interest is paid is where just one of the nuances begins. Interest payments can be made regularly in monthly or yearly instalments or at the end of the fixed income investment's term. Such fixed income securities are called bonds, and they are one of the most common fixed-income investments.
Some investors buy individual bonds or other securities to hold them until their maturity dates. However, it is also possible to buy and sell bonds as they go up and down in value. That's where one of bonds' most considerable complexities come into play. Bond prices move inversely to the broader interest rate environment. So when interest rates go up (often perceived as a good thing), bond prices go down.
What are the benefits of fixed income investing?
Price movements in bonds do present an investment opportunity, however. Plus, there are other benefits to fixed income investing.
Bonds and other fixed-income instruments react differently to macroeconomic factors like changes in Government policy in comparison to stocks and shares. That is helpful when structuring a portfolio as it is a means of limiting losses. By diversifying your portfolio with a different asset like bonds, you make the portfolio less sensitive to the news cycle. In doing so, it means that should one of your asset classes have a day where its price plummets, you do not lose nearly as much portfolio value if you had solely invested in that class.
Bonds and other fixed-income securities are a loan. As a result, they can help preserve capital and protect it. That’s because you are all but guaranteed that you will receive back what you initially invested and with some interest too. Fixed income securities are usually less risky than assets like stocks which can fall to zero. That's why they are often a heavy component of a person’s portfolio when they are nearing retirement. Bonds are commonly a large portion of asset allocation in a pensioner’s retirement fund as a pensioner has less time to recoup losses.
A significant benefit to fixed income securities is that they can provide an investor with another income stream. And it is fixed. Hence the name. That’s another reason that bonds are popular with pension fund managers. They are far easier to ensure that the future outgoings are equal to or less than the income. That is the case for anyone holding a bond themselves, not as part of a larger pension fund pot. So were you to buy a bond, you could be sure that you could rely on its income in the future at regular intervals - much like you do a salary.
Finally, as alluded to above, bonds can achieve growth and, therefore, a return on investment. Plus, when weighing up which bonds to buy, it can be more straightforward to calculate which bonds will usually attract higher returns. Much like stocks, riskier bonds will have the potential to grow more, plus they typically come with a higher interest rate, known as the coupon, to reimburse investors with a higher interest income and coupon payments for taking on higher risk.
What are the disadvantages to fixed income investing?
Given that all of the above sounds very enticing, what are the disadvantages of investing in a fixed income asset? It is essential to understand the below risks to conclude whether this is the suitable asset class for you or if you have a particular bond in mind that that bond has the right balance of risk versus potential reward.
One of the main problems with fixed income investing is the risk of default - the chance that the company that issued the bond may go bankrupt. They will, therefore, not be able to meet their debt repayments which is what a bond is - a share of their debt. As a result, you may not receive back all, or any, of your initial investment. However, you should know how risky a bond's issuer is from the start. That's thanks to the credit ratings assigned by credit rating agencies like Moody's. Bonds with AAA ratings are the least risky (often assigned to countries like the UK or USA). Riskier bonds will attract a creditworthiness rating of C+ or lower.
Inflation risk is the risk that inflation may increase to a higher level than the interest rate on the bond. That's because inflation means you will need more money to buy the same amount of goods in the future. As a result, the income you would receive loses its purchasing power over time. Frustratingly, you will only ever know if it would have been better to spend your money than to invest it in a bond - where it technically loses value through inflation - in hindsight.
Interest rate risk
Interest rate risk occurs when interest rates rise, causing bond prices to go down in value. As a result, any bond you hold is worth less if you were to sell it. Interest rate risk is perhaps the most considerable risk that fixed-income investors face. They are the most significant source of volatility in fixed-income markets.
Finally, there is always the chance that should you want to sell your bond, there is not another investor who wants to buy it. While that is the case for all investments, it is still one that is a possibility that you should bear in mind when deciding whether to buy a particular bond or not. Some will be more liquid than others.
What fixed-income investments offer the best returns?
Bearing these risks in mind, what fixed-income investments will provide you with the best return on your initial outlay? Of course, there are more ways to invest in fixed income than just to buy a bond or two. But, as ever with investing, it is essential to weigh up the below potential investments remembering your own circumstances.
For example, while a bond could offer the chance of a high return, it may do so with a considerable element of risk. If you cannot afford to take that chance, it does not matter what return you could potentially make. Therefore, it is more prudent to research other forms of fixed-income investments other than one or two bonds. Doing so means you can determine whether their potential return is worth the risks posed to your own situation.
Mutual funds are a selection of investments actively run by a fund manager. A fund manager decides what to buy according to an investment target and outlook. For example, if you wanted exposure to bonds, you would purchase a mutual fund that invests in fixed income. As a result, you can gain exposure to specific fixed-income investments while making the most of a fund manager's experience. You can even choose to invest in particular funds (to achieve higher than market returns) by investing in specific sectors or credit standards.
Exchange-traded funds are a lot like mutual funds. They are a way of an investor buying one or more units of a fund. Yet, within that fund, there are several investments. Therefore, your investment's value is linked to what the fund is worth and how much of it you own. Exchange-traded funds track indexes or sectors or assets like bonds - so they do not try to beat the markets as a mutual fund would do. In that way, they are passive investments. However, as you buy and sell units in ETFs, you can diminish the case of liquidity risk.
Of course, it is possible simply to buy just one bond or several from a dealer. That way, you get to set up your portfolio of bonds and manage it actively. For example, you can pick from Government bonds, corporate bonds or high yield bonds - which are low, medium and high risk, respectively. What's great about picking your particular bonds is that you are in charge of your pickings, not a fund manager. Though, for some, that may be a drawback.
Fixed income investing
Fixed income investing is a complicated beast at times - mainly if you buy your own bonds instead of investing in a mutual fund or ETF. However, they can be crucial to your portfolio, especially if you are nearing retirement. They are seen as relatively low risk compared to other investments and assets. Not all bonds will be suitable for all investors, but they can be an appropriate investment for many.