Fixed income securities are an asset class that aims to preserve the investor’s capital (initial investment) while providing a steady stream of income. This ability to provide protection and income makes it a less risky asset class than others. On the other hand, it also means that you are likely to receive lower returns than other asset classes, such as stocks .
Want to know more about what an asset class is and what other types are? See our article titled “What is an asset class?” » .
There are many layers to how fixed income securities work and behave in the markets. But don’t worry, we’ll How does a fixed income security work?
Fixed income securities consist of paying investors a fixed amount until a specified maturity date. Both the payment amount and the due date are predetermined. Payments are then usually made in the form of interest. At the end of the maturity period, investors get back their initial investment.
For example, a government issues a 2.5% bond with a face value of $500 that matures in 10 years. The investor buys the bond for $500, which amounts to lending this money to the state. Over the 10 years, the investor receives an interest payment (usually monthly, quarterly or annually) based on a rate of 2.5% per annum. In the tenth year (maturity date), the investor is reimbursed for his initial investment of $500.
What are the advantages?
As we have seen, fixed income securities have a few more components than an average investment, but it also offers the possibility of enjoying more advantages!
Fixed income securities are about preserving the value of the original investment. They are therefore an excellent tool for investors close to retirement or with a shorter investment horizon, who would not have time to compensate for significant losses.
Providing regular income is another reason why this asset class can be an effective investment tool for retirement. And that can offset receiving lower total returns over the long term.
Considered less risky than stocks, fixed income securities can help diversify your portfolio from stock market risk. If the markets crash, your fixed income assets can offset those losses.
Although less risky, fixed income securities offer some opportunities to increase the overall value of your investment. A company with a low credit rating can offer its investors a higher yield to compensate for the additional risk they are taking (instead of buying a government bond or bonds from a company with a lower credit rating). is higher). This could result in a higher potential return.
What are the risks?
Fixed income investments are designed to minimize risk in your portfolio. However, as with any investment, there are always a few things to consider.
Bond prices are inversely proportional to interest rates. So when interest rates rise, bond prices fall. If you have to redeem your bond before the maturity date, you risk incurring losses.
Fixed income payments are… fixed . So if the rate of inflation is higher than your payments, the value of every dollar you get has less purchasing power.
Credit or default
Remember that a bond is like a loan, which means there is a risk of issuer default. Fortunately, bonds have ratings that reflect the financial strength of the issuer, allowing you to decide how much risk you want to take.
Some bonds can be less liquid than traditional stocks and the difference between the price you want to sell and the price buyers are willing to pay (called the spread) can be significant, making it more difficult to exit before maturity.