When we talk about income, we can separate it into two categories, fixed income and variable income. Variable income is a type of investment where the remuneration is not known at the time of application. The most common example of variable income investments are stocks, or shares. Its prices are always changing and it’s not easy to know how much money the investor is going to make, or if it is going to make any at all.
On the other hand, fixed income refers to investments that pay fixed interest until the maturity date and, at maturity, investors are paid the amount that they previously invested. In other words, it is an investment that usually results in predictable returns paid regularly, at a dividend or interest rate that is known in advance. They are issued by governments, corporations or other entities to finance their operations. The most common types of fixed income securities are corporate, government and treasury bonds and bank deposit certificates.
Although variable income products are considered more risky (higher volatility) than fixed income products, they provide a better return, and that’s why they are so important in portfolios.
Wheighting the Pros and Cons
Acquiring fixed income is a great way to diversify portfolios. They are considered low risk compared to equities, in the sense that some are backed by the governments. But even if they aren’t, if the instrument is highly rated, the chances of the issuer defaulting on the payment are almost zero. Nevertheless, during the 2008 financial crisis many rating agencies were not providing accurate ratings. Assuming high grade fixed income products have lower risk, the interest coupon payments are also lower. Because these instruments have a fixed interest rate, they are a great way to generate a more or less steady flow of income. Investing in Fixed income can potentially balance the losses when stock markets swing (market risk), considering that these assets are less sensitive to macroeconomic fluctuations. Moreover, when companies file for bankruptcy, lenders of the company (those who own bonds) are paid before those who hold equity (shares).
But investing in this type of securities also has its risks, such as changes in interest rates. Given the low returns offered by bonds in Europe, for example, the investor may be losing money to inflation. People should also pay attention to the rating of the bond since bonds rated below BBB are considered junk bonds (low quality). And, even though the risk of the issuer missing the timely payments is minor, there is still a possibility that it does.
So why invest in fixed income assets?
The percentage of fixed income in a portfolio depends on the investor’s risk profile. Investing too conservatively may expose a portfolio to inflation risk, but investing too aggressively may expose a portfolio to market risk. If you aim to earn steady returns with low risk, participating in the fixed income market might be the best option.
The best option would be investing through mutual funds. These funds invest in different types of fixed income securities and offer a high return, in general. Another option would be Exchange traded funds (ETFs), which buy debt securities and guarantee stability since returns are provided periodically at a fixed rate.
It is also possible for an individual investor to buy a fixed income asset, but the minimum investment requirements are high, as also are the transaction costs. Furthermore, due to the high threshold, it might be difficult to sell in the bond market.
This article is in our October Newsletter 2020
Margarida Pardal, BSc Economics