If you’re looking for an approach that may offer steady, predictable income without selling assets, fixed income investing could be an option to consider.
In this article, we’ll define fixed income investing, explain how it works, outline common asset types, and discuss the pros and cons to help you decide how much of your portfolio you may want to allocate.
What is fixed income?
A fixed income investment is any asset that pays an investor a set amount of money on a predetermined schedule. Bonds, certificates of deposit (CDs), fixed annuities, and some alternative investments fall under the category of fixed income.
Fixed income investing focuses on generating regular income by investing in securities—such as bonds—that pay interest over time.
How does fixed income work?
While different types of fixed income securities work in slightly different ways, they share a common principle: When you purchase one, you’re entitled to receive a set income on a schedule defined by the terms of the security.
Some characteristics that fixed income investments tend to share include:
- A stated rate of return: Unlike some investments that might offer changing returns or income, such as dividend-paying stocks, fixed income investments are designed to pay a set amount of interest on a regular schedule and the face or notional value of the instrument at a future date. A bond's yield gives investors a sense of the investment’s potential outcome if it is held until repayment and the issuer meets its obligations.
- Steady schedule: A fixed income investment makes payments according to whatever payment schedule is specified in its terms, which can include monthly, quarterly, semi-annually, or annual payments.
- Generally lower risk: Many fixed income securities—such as government and municipal bonds, CDs, and annuities—are often considered to have relatively low chances of losing the money you’ve invested.
- Risk-adjusted returns: Because fixed income investments are generally lower risk, they often provide more modest returns compared to higher-risk assets like stocks.
- Principal repayment: Many fixed income securities, such as bonds, typically have a set maturity date, at which point you’re scheduled to receive your principal back.
Types of fixed income investments
Fixed income includes a range of asset classes, each with its own features, advantages, and drawbacks to consider.
Certificates of deposit (CDs)
A certificate of deposit (CD) is a savings product offered by banks that usually pays a higher interest rate than what is offered by traditional savings accounts. Many investors build CD ladders from multiple CDs to generate income over the long term.
When you buy a CD, you agree to leave your money in place for a set period of time—typically anywhere from 1 month to 5 years, with some longer options available. In return, you receive fixed interest payments on a regular schedule. When the CD reaches maturity, you get back your original deposit along with any final interest, if the CD hasn’t been called early. If it is called early, your original deposit is returned at that time.
You can buy CDs directly from a bank, or through a brokerage (called brokered CDs). CDs are FDIC insured up to $250,000 per account holder, per institution, per ownership category, just like other types of bank accounts.
While CDs may offer a relatively safe way to earn income, their yields are often lower than those of riskier investments, which can make inflation a potential concern. Also, withdrawing funds before maturity could lead to penalties, such as losing interest.
Treasurys
Treasurys are sold by the United States Treasury to fund the federal government. These are the most common types of Treasurys:
- Treasury bills (T-bills): Short-term securities that mature in a year or less.
- Treasury notes (T-notes): Medium-term securities that mature in 2, 3, 5, 7, or 10 years.
- Treasury bonds (T-bonds): Long-term securities that mature in 20 or 30 years.
Buying a Treasury security gives you fixed interest payments on a set schedule. T-notes and T-bonds pay interest every 6 months, while T-bills are sold at a discount, and your return is the difference between the purchase price and the face value at maturity. When the security matures, you’ll also get back your principal. Plus, interest from Treasurys is exempt from state and local income taxes.
You can buy Treasurys directly from the US Treasury by opening a TreasuryDirect account, or on the secondary market through a brokerage.
Like CDs, the return on Treasurys can be fairly low when compared against higher-risk investments. Interest payments also tend to be less frequent than many other fixed income securities.
Bonds
A bond is debt issued by a borrower—such as a government, municipality, or corporation. When you buy a bond, you’re essentially lending money to the issuer in exchange for regular fixed interest payments. At maturity, you’ll receive your original principal back, similar to Treasurys and CDs.
A bond’s risk—and its yield—largely depends on the type of bond.
- Agency bonds are issued by government agencies or government-sponsored enterprises (GSEs). They generally carry more risk than Treasurys but less than corporate bonds.
- Municipal bonds are issued by states, counties, cities, and towns. They’re generally considered riskier than Treasurys, and while uncommon, defaults can occur.
- Corporate bonds are issued by businesses. Their risk level can vary widely depending on the financial health of the issuing company, which is assessed by credit rating agencies. High-quality, investment-grade corporate bonds are generally considered low risk, while high-yield (or “junk”) bonds carry higher risk in exchange for potentially higher payments.
You can purchase bonds directly from issuers or on the secondary bond market through a brokerage account.
While bonds are often considered to be low-risk investments, they are not free of risk. Issuers can default, leading to loss of principal. As with Treasurys and CDs, low yield can raise concerns about inflation and interest rate risk.
Deferred fixed annuities
A deferred fixed annuity (sometimes called a single premium deferred annuity, or SPDA) is a contract with an insurance company. You put in a lump sum of money, and the insurer credits interest at a fixed rate for a set period, often between 3 and 10 years.
During this time, the annuity earns interest, and that interest is added to your balance on a regular basis. You usually don’t pay taxes on the earnings until you take money out.
One feature of fixed deferred annuities is tax deferral, which can allow money to grow over time without immediate tax impact.
However, taking money out early could lead to a surrender charge, a market value adjustment,1 or both. Many insurers allow limited withdrawals each year—often up to 10% of the annuity’s value—without charges. Withdrawals of taxable amounts from an annuity are subject to ordinary income tax, and, if taken before age 59½, may be subject to a 10% IRS penalty.
You can purchase an annuity either from an insurance company itself or through a bank or brokerage. Since annuities are subject to the claims-paying ability of the issuing insurance company, it’s important to consider the insurer’s ability to meet its future obligations.
Fixed income annuities
Another type of fixed annuity is a fixed income annuity, which is also a contract with an insurance company. It is designed to provide regular payments either for a set period or for life in exchange for a lump sum investment.
There are 2 common types:
- Single premium immediate annuity (SPIA): Payments begin within a year of purchase. These can be used by people who want predictable income soon, such as around retirement.
- Deferred income annuity (DIA): Payments start at a later date you choose, more than a year in the future. You may fund the annuity with a lump sum or periodic contributions. These can be used by people who want to lock in an income stream as they transition to retirement.
Some fixed income annuities offer optional features, such as annual increases or protection for beneficiaries. These options usually reduce the size of the income payments.
Once a fixed income annuity is purchased, access to the original investment is often limited or unavailable. As with all annuities, payments and guarantees are subject to the claims-paying ability of the issuing insurance company, making insurer stability an important factor to review.
Other investments
Beyond the well-known asset classes, there are also lesser-known investments that can generate fixed income, such as:
- Credit Union Share Certificates (CUSCs): Like CDs, these are issued by credit unions rather than banks. Functionally identical to bank CDs, these are issued by credit unions. When you open a share certificate, you lock in a fixed dividend rate for a specific term. They are insured by the National Credit Union Administration (NCUA) up to $250,000.
- Mortgage-backed securities (MBS): These products pool together mortgages from multiple homeowners. However, MBS carry significant prepayment risk. If interest rates fall, homeowners may refinance their mortgages, causing your principal to be returned earlier than expected and forcing you to reinvest at lower rates. Conversely, if rates rise, homeowners are less likely to refinance, locking your capital in a lower-yielding asset.
Potential advantages of fixed income investing
Some reasons investors often consider adding fixed income securities to a portfolio include:
- Predictable income: Fixed income securities typically provide scheduled payments, which can offer a steady source of income, particularly for those focused on retirement planning.
- Generally low risk: While not entirely risk-free, many fixed income investments tend to involve less risk of principal loss compared to certain other asset types, especially when held to maturity.
- Capital preservation: Because these securities can generate income without requiring the sale of other assets, they may help maintain your overall capital while covering expenses.
- Diversification: Including fixed income securities can add variety to a portfolio that might otherwise be concentrated in equities.
Potential disadvantages of fixed income investing
Likewise, here are some of the potential drawbacks of fixed income securities to consider:
- Lower returns: Because these investments generally carry less risk, they often provide lower returns compared to higher-risk assets such as stocks. This may make them less appealing for investors seeking significant growth or with longer time horizons.
- Inflation impact: Lower returns can mean that fixed income investments may not keep pace with inflation, which could reduce purchasing power over time.
- Not entirely risk-free: While fixed income securities typically have a lower risk of principal loss, they are still subject to several risks—particularly if sold before maturity. These include interest rate risk (the value of existing bonds falls when new bonds are issued at higher rates), credit risk (the issuer could default), inflation risk, prepayment risk (primarily with MBS), and liquidity risk (the inability to sell an asset quickly without a significant loss in price).
Are fixed income investments right for you?
Your portfolio strategy—how you allocate different asset classes—usually depends on things like how much risk you’re comfortable with, how long you plan to invest, and what you’re trying to achieve financially. Sometimes, people decide to put more of their money into fixed income investments when:
- A relatively steady income stream is a priority, along with preserving the portfolio’s overall value.
- Retirement is approaching—or has already begun—or the investment timeline is shorter, reducing the ability to bounce back from potential losses in other types of investments.
- A more conservative approach is preferred, with less comfort putting a large share of the portfolio into equities or other higher-risk options.
- The portfolio may already be heavily weighted toward equities, prompting consideration of ways to increase diversification.
Fixed income investments can play an important role in a well-balanced portfolio by offering stability, income potential, and diversification. They may not deliver the same growth opportunities as equities, but they can help manage risk and provide a measure of predictability. As with any investment decision, it’s important to consider your individual goals, time horizon, and risk tolerance before determining the right allocation.