Fixed-Income Security

Key takeaways

• Fixed-income securities pay predictable interest (coupons) and return principal at maturity.
• Common types include government debt (T-bills, notes, bonds), municipal bonds, corporate bonds, CDs, savings bonds, and preferred stock.
• Risks include interest-rate risk, inflation risk, credit/default risk, and liquidity risk.
• Fixed income is useful for portfolio diversification and stable income; tax treatment varies by instrument.

What is a fixed-income security?

A fixed-income security is a debt instrument issued by a government, municipality, or corporation that pays periodic interest and returns the principal at a specified maturity date. Investors effectively lend money to the issuer in exchange for scheduled income and repayment. Compared with equities, fixed-income investments generally offer lower volatility and more predictable cash flow.

How fixed income works

• You buy the issuer’s debt instrument and receive periodic interest payments (often semiannual).
• At maturity, the issuer repays the principal (face value).
• Some instruments (e.g., T‑bills, zero‑coupon bonds) are issued at a discount and pay no periodic coupons; you receive face value at maturity.
• Returns and risk vary by issuer credit quality, term (maturity), and market interest rates.

Common types of fixed-income securities

• Government debt
• Treasury bills (T‑bills): Short-term (4–52 weeks), issued at a discount, considered very low risk.
• Treasury notes (T‑notes): Intermediate-term (2–10 years), pay semiannual interest.
• Treasury bonds (T‑bonds): Long-term (20–30 years), pay semiannual interest; interest is exempt from state and local taxes.
• Treasury Inflation-Protected Securities (TIPS): Principal adjusts with inflation to protect purchasing power.
• Municipal bonds (munis)
• Issued by state or local governments to fund public projects. Interest is often exempt from federal income tax and may be exempt from state/local tax for residents of the issuing jurisdiction.
• Corporate bonds
• Issued by companies for capital needs. Range from investment-grade (lower default risk) to high-yield/junk (higher default risk, higher yields).
• Certificates of Deposit (CDs)
• Bank or credit-union deposits with fixed term and interest rate; typically insured by the FDIC or NCUA up to limits.
• U.S. savings bonds
• Government savings instruments that earn interest over long terms (up to 30 years); interest is exempt from state and local taxes.
• Preferred stock
• Hybrid security that pays fixed dividends but represents equity rather than debt; dividends can be suspended and there is typically no maturity.

Credit ratings and default risk

Independent agencies (Moody’s, S&P, Fitch) rate issuers and issues to indicate default risk:
* Investment-grade: BBB−/Baa3 and above — lower default risk.
* Speculative-grade (high-yield/junk): BB+/Ba1 and below — higher default risk, higher potential returns.
Government-backed U.S. Treasuries are generally treated as the safest credit exposure.

Advantages

• Predictable income stream and scheduled return of principal.
• Lower volatility than equities, helping stabilize portfolios.
• Useful for diversification and income-oriented goals (retirement, cash flow).
• Certain instruments offer tax benefits (e.g., municipal bonds, Treasury interest exempt from state/local taxes).

Disadvantages and risks

• Lower long-term returns than many equities.
• Interest-rate risk: bond prices fall when market interest rates rise.
• Inflation risk: fixed payments can lose purchasing power over time.
• Credit/default risk: issuer may miss payments or default.
• Liquidity risk: some bonds can be hard to sell without price concessions.
• Reinvestment risk: coupons or matured principal may have to be reinvested at lower rates.

Bond funds vs. individual bonds

• Individual bonds
• Provide a known principal repayment at maturity if held to term.
• Require more capital to build diversification across issuers and maturities.
• No ongoing management fees.
• Bond funds (mutual funds/ETFs)
• Offer instant diversification and liquidity.
• Net asset value fluctuates with market interest rates; principal is not returned at a specific maturity.
• Charge management fees and may have taxable distributions.

Choose based on goals: individual bonds for predictable returns and defined maturity; bond funds for convenience, diversification, and liquidity.

Role in a portfolio

Fixed income can:
* Reduce overall portfolio volatility.
* Provide steady income and capital preservation for conservative investors or near-term goals.
* Act as a counterbalance to equity risk, though allocation should reflect your risk tolerance, time horizon, and income needs.

Tax considerations

Tax treatment varies:
* Municipal bond interest is often federal tax‑exempt and may be state‑exempt for local residents.
* U.S. Treasury interest is subject to federal tax but exempt from state and local taxes.
* CDs and most corporate bond interest are taxable at the federal, state, and local levels.
Check specific instrument rules and consult a tax advisor for individual circumstances.

Conclusion

Fixed-income securities are instruments for lending capital in exchange for scheduled income and principal repayment. They offer stability, diversification, and predictable cash flow, but come with trade-offs including lower returns and exposure to interest-rate, inflation, and credit risks. Selecting the right mix of individual bonds, bond funds, and specific fixed-income types depends on your investment goals, time horizon, and tax situation; consider professional advice when building a fixed-income strategy.