Fixed income investments are one of the most popular options for those seeking stability and consistent returns on their investments. But what do we mean by these types of investments? Read on to learn more about this financial strategy, how they work, and why they could be an excellent option for your investment portfolio.
What are fixed income investments?
Fixed income investments are financial instruments that offer a predictable income stream to investors. In simple terms, when investing in fixed income, you lend your money to an entity (government, company or institution) in exchange for receiving periodic interest payments, and at the end of the agreed term, you get your initial capital back. Unlike equity investments, fixed income investments offer predictable payments and generally a lower level of risk.
How do they work?
When you buy a fixed income instrument, for example a bond, you are essentially acting as a lender. The issuing entity agrees to pay a fixed interest at regular intervals and repay the principal on the maturity date. The interest you receive is known as the “coupon”, and its rate depends on factors such as the duration of the bond and the creditworthiness of the issuer.
Simple example of how it works:
Imagine you invest $10,000 in a 5-year bond with a 5% annual interest rate. Each year you would receive $500 in interest, and at the end of the 5 years, the entity would return your initial $10,000.
Types of fixed income investments
There are different types of fixed income investments, and choosing the most appropriate one will depend on your objectives and risk tolerance. Below are the most common types:
- Government bonds. These are issued by national or local governments. Examples include Treasury Bonds in the United States or Cetes in Mexico. They are considered very safe investments, since they are backed by the government. Although the return on investment is considered to be low compared to others.
- Corporate Bonds. Issued by private companies to finance their projects and operations. They usually offer higher interest rates than government bonds, but also carry a higher risk.
- Certificates of Deposit (CDs)
Certificates of Deposit or Cedes are term investments in local currency. They allow monthly yields to be obtained at a fixed rate in effect at the branch or at a variable interest rate that is adjusted monthly.
Advantages and disadvantages of fixed income investments
Advantages:
- Income stability: They offer predictable interest payments, which provides a steady stream of income. Thus, you have greater peace of mind about the markets.
- Lower risk: Generally, they are less volatile than equity investments, which makes them ideal for investors seeking security. Although the recommendation is always to adapt it to your preferences.
- Diversification: Including fixed income investments in your portfolio can help reduce overall risk, in addition to taking advantage of those that are not.
- Liquidity: Some instruments, such as government bonds, are easily convertible into cash prior to maturity. We invite you to read our article on How to maintain an adequate liquidity balance in your investments?where you can learn more about this type of strategy.
Disadvantages:
- Limited returns: They generally offer lower returns than equity investments. Suppose you invest $10,000 in a 5-year government bond with a 3% annual interest rate. After the first year, you will earn $300 in interest. However, if you had invested that same money in stocks of a company with solid growth, you could have earned a 10% return, or $1,000 instead of the $300 you earned with the fixed-income investment. Although fixed income investments are safer, their return is significantly lower compared to equity investments.
- Inflation risk: If the inflation rate exceeds the interest rate of your investment, you could lose purchasing power. Imagine you have a bond with a 2% annual interest rate. If inflation over the same period is 4%, your investment will be losing value in real terms. Even if you continue to receive your 2% interest, the goods and services you could buy with that money will be more expensive due to inflation, which means that your purchasing power will be reduced.
- Credit risk: There is a risk that the issuing entity may not be able to meet its payment obligations. Suppose you invest in corporate bonds issued by a private company offering an attractive rate of 6% per annum. However, after two years, the company enters into financial difficulties and is unable to meet its payment obligations, resulting in a default. This could result in the loss of part or all of the invested capital. Although this risk is lower in government bonds, it is a possibility in corporate or municipal bonds.
How to choose the right fixed income investment?
Selecting the right fixed income investment can make all the difference in your financial strategy. Here are some key tips:
- Evaluate your risk profile. Before investing, consider your risk tolerance. If you’re looking for safety and stability, government bonds may be the ideal choice. If you’re willing to take on a little more risk for better returns, corporate bonds may be an alternative.
- Define your financial goals. Before you start investing, ask yourself: Are you looking for steady income or are you investing for the long term? Defining your objectives will help you choose between short- and long-term fixed income instruments.
- Understand the interest rate structure. Interest rates can significantly affect the value of your fixed income investments. For example, if interest rates rise, the value of existing bonds tends to fall. It is critical to understand this dynamic before investing.
Fixed Income Investments
Fixed income investments are an excellent option for those seeking a stable income stream and a lower level of risk in their portfolio. Whether you prefer government bonds, corporate bonds or certificates of deposit, it is important to evaluate your financial objectives, risk profile and market conditions before making a decision. Investing in an informed manner will allow you to take full advantage of the benefits these types of investments have to offer, helping you achieve your long-term financial goals.
This guide is just the beginning of your journey into the world of fixed income investments. Remember that financial education is the key to making sound decisions and building a solid and diversified portfolio.
If you need more information or advice on how to include fixed income investments in your portfolio, do not hesitate to contact us!
