Asset Classes - Fixed Income

June 12, 2018

Today is the second of a four-part series on the different types of asset classes, and we are talking Fixed Income. Previously, we discussed the different ways to diversify with stocks.

asset classes

Fixed income or Bonds

The term fixed income is slightly misleading. With the word “fixed” in there, you might think that it’s, well, fixed, and that you will get a set amount of income from this type of investment. Sometimes that is true, but sometimes it isn’t. Usually, there is some kind of fixed payment attached to this type of investment, which is why it’s called fixed income. But sometimes, the bond may not make a fixed payment until it matures, or for various other reasons, there is not a fixed payment.

Fixed income could mean bond funds, bond ETFs, individual bonds, even the savings bonds you got for your high school graduation that you may have lying in a lock box somewhere.

Let’s define some terms.

Bond: most of us are familiar with the savings bond we received from our Aunt Phyllis for our confirmation/bar mitzvah/second birthday. Whereas a stock represents ownership in a company, a bond is considered a debt instrument. Bonds are an investment in which an investor loans money to an entity (company, government, etc.) who borrows the funds for a certain period at a certain interest rate. When Aunt Phyllis bought you a savings bond, she gave the government some money, and they agreed to pay it back, with interest, for a set period. There are many, many different types of bonds, and we’ll get into some of the differences in a bit. If you have an individual bond, this means you hold an agreement with a specific entity, that has terms attached. Some of these terms defined are:

The bond has a face value, which is the amount that the bond will be worth at maturity.

The maturity date is the date on which the bond will mature, and the bond issuer will pay back the face value to you.

The bond has a coupon rate, which is the rate of interest the bond issuer is going to pay you. For example, if the coupon rate is 5%, the bond issuer is going to pay you 5% interest on the bond every year. The actual payment is known as the coupon payment.

The coupon dates are dates when the bond issuer will make the coupon payments to you.

Bond ETF: exchange traded fund that owns different types of bonds. See *here* for what is an exchange traded fund.

So, what are some different ways to diversify amongst bonds, etc.? Glad you asked. We can break this down in several ways:

Breakdown by maturity: The maturity of the bond is the period until the principal must be paid back. If you buy an individual bond, that has a 10-year maturity, that means that the bond issuer has 10 years before they need to pay you back the principal money you invested in the bond. Typically, there are three types of bond maturities:

  • Short—terms from less than a year to up to 5 years
  • Long—20 to 40 years
  • Intermediate—largely whatever is in between—this one is sometimes hard to define, since sometimes a 3-year bond is considered intermediate, but generally 5-20 years is the length

Breakdown by credit-quality: The credit quality of a bond refers to the credit worthiness, or risk of default. Is the bond issuer good at paying their debt, or have they defaulted in the past? There are rating agencies that rank bonds, and they issue various letter ratings to show where the bond is on the scale of credit worthiness. You may have heard of things like “investment-grade” or “junk” bonds. Those are all bond lingo for different ratings.

Breakdown by issuer type: Corporations issue bonds to raise money, and so does the government. Government bonds are considered more conservative because they are backed by the government, which has the power to raise tax to cover the bond payments if necessary. Government agency bonds are issued by federal agencies like Fannie Mae (FNMA or Federal National Mortgage Association). Finally, there are municipal bonds, which are issued by a U.S. state, city, town, etc. so that they can raise money to pay for things like a new water plant.

Breakdown by location: just like with stocks, we see bonds coming from different places other than the U.S. also. The same categories of U.S., international developed countries, and emerging markets apply.

Breakdown by coupon type: You can have bonds that pay regular coupon payments, but you may also have what is known as a zero-coupon bond, which doesn’t make payments. Instead, these bonds are issued at a deep discount, and the idea is that when it matures, that’s when you get back the face value plus all the coupon payments it would have made, all at once.

Why would you even want to consider a bond in the first place? Well, it’s because fixed income typically does generate regular income, helps to manage portfolio risk, and helps to protect against stock market volatility. The fixed income securities generally offer more stability than equities. This is not to say they are without risk. There still is risk, but generally, you own bonds in your portfolio because you want to have something relatively stable that can still generate a higher return than having your money sit in cash.

Don’t forget to tune into the next blog article, where we dive into different types of cash and why it’s still important to have some of that in your portfolio.

The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Jill Carr and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Diversification and asset allocation do not ensure a profit or protect against a loss. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. Investing in emerging markets can be riskier than investing in well-established foreign markets. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise.

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