What Is Fixed Income? Types of Fixed-Income Investments

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Fixed income is a category of investments in which an investor provides money to a borrower, usually a government, a company or a bank, and in return receives payments on a schedule set in advance, plus the return of the original amount at a stated maturity date. Bonds are the standard example. “Fixed” describes the payment terms the borrower agrees to at the outset, not the market price of the investment or the certainty of being paid. A bond’s price can move every trading day, and an issuer can default. What stays fixed, for a conventional bond, is the coupon rate, the payment dates and the amount owed at maturity.

How Fixed Income Works

Governments and companies issue debt to pay for operations and large projects without selling ownership. The security they sell spells out the borrower’s obligations:

• Face value (par): the amount the issuer repays at maturity, often $1,000 per bond for corporate issues. Treasury securities are sold in multiples of $100.
• Coupon rate: the annual interest rate applied to face value. A 5% coupon on $1,000 of face value pays $50 a year.
• Payment frequency: coupons may be paid semiannually, quarterly or monthly. Many U.S. bonds, including Treasury notes and bonds, pay twice a year.
• Maturity date: the date the principal is returned and the obligation ends.

Some instruments pay no coupon at all. A Treasury bill or a zero-coupon bond is bought at a discount to face value, and the investor’s interest is the difference between the purchase price and the amount received at maturity.

Worked Example: A Five-Year Corporate Bond

Hypothetical example. A company issues a five-year bond with a 5% fixed coupon, $1,000 face value and semiannual payments. An investor buys 10 bonds at par for $10,000.

• Annual interest: 0.05 × $10,000 = $500
• Each semiannual payment: $500 ÷ 2 = $250
• Total interest over five years: $500 × 5 = $2,500
• At maturity: the issuer repays the $10,000 principal

Assuming the company makes every payment and the investor holds to maturity, the investor receives $12,500 in total cash for a $10,000 outlay, while the company has used the $10,000 to fund its project.

Two assumptions carry that result. If the company defaults, payments stop and recovery of principal depends on bankruptcy proceedings. If the investor sells before maturity, the price received depends on market interest rates at the time of sale and could be above or below $1,000.

Interpreting Prices and Yields

Once a bond is issued, it trades in the secondary market, mostly over the counter through dealers rather than on a central exchange. Its coupon does not change, so its price adjusts to bring its return in line with what new bonds offer.

Hypothetical example. An investor holds a bond paying a 4% coupon ($40 a year on $1,000 of face value). Market rates rise and comparable new bonds now pay 5%. No buyer will pay $1,000 for $40 a year when $1,000 buys $50 a year elsewhere, so the older bond’s price falls until its return is competitive. If rates had instead fallen to 3%, the 4% bond would be worth more than par. This is why bond prices go down when interest rates rise, and up when they fall.

Two simple measures express return relative to price:

• Current yield = annual coupon ÷ current price. A $40 coupon on a bond priced at $950 gives a current yield of about 4.21%.
• Yield to maturity (YTM) accounts for coupons plus the gain or loss as the price converges to par at maturity, assuming all payments are made and coupons are reinvested at the same rate.

The size of the price move for a given rate change is measured by duration. A common approximation:

% price change ≈ −modified duration × change in yield (in percentage points)

Hypothetical example. A bond with a modified duration of 6 would lose roughly 6% of its price if yields rose by one percentage point, and gain roughly 6% if they fell by one point. The approximation works best for small rate changes. Duration rises with longer maturities and lower coupons, which is why a 30-year bond reacts far more to a rate change than a one-year bill.

Types of Fixed-Income Investments

Fixed-income assets differ mainly by who borrows, how long the loan runs, how interest is set and what backs the promise.

U.S. Treasury Securities

Treasuries are issued by the U.S. government and backed by its full faith and credit. They can be bought directly through TreasuryDirect or through a broker. Interest on Treasuries is subject to federal income tax but exempt from state and local income tax.

• Treasury bills (T-bills): mature in one year or less and pay no coupon. They are sold at a discount and repaid at face value.
• Treasury notes (T-notes): mature in two to 10 years and pay a fixed rate every six months.
• Treasury bonds (T-bonds): work like notes but mature in 20 or 30 years.
• Treasury Inflation-Protected Securities (TIPS): the principal adjusts with inflation and deflation as measured by the Consumer Price Index. The fixed coupon rate is applied to the adjusted principal, so the dollar interest rises when inflation lifts the principal.

Municipal Bonds

Municipal bonds (“munis”) are issued by states, cities, counties and other local authorities to finance public spending such as schools, roads and utilities. Interest on many munis is exempt from federal income tax, and sometimes from state tax for residents of the issuing state. Munis are not backed by the federal government; their credit quality depends on the issuer and on whether the bond is backed by general taxing power (general obligation bonds) or by a specific revenue source such as tolls (revenue bonds).

Corporate Bonds

Corporate bonds are issued by companies, and the rate an issuer must pay depends largely on its creditworthiness. Bonds rated BBB- (S&P and Fitch) or Baa3 (Moody’s) and above are investment grade. Higher-rated bonds, such as AAA issues, generally pay lower coupons because investors demand less compensation for default risk. Bonds rated below investment grade are high-yield or junk bonds and pay higher coupons because the risk of default is higher.

Corporate bonds also come with structural features:

• Callable bonds let the issuer repay early, typically when rates have fallen and it can refinance more cheaply.
• Convertible bonds can be exchanged for a set number of the issuer’s shares, giving bondholders some exposure to the stock.
• Commercial paper is short-term, unsecured corporate debt used to fund near-term needs such as payroll and inventory.

Certificates of Deposit

A CD is a time deposit with a bank or credit union that pays a set rate for a set term. CDs are grouped with fixed income because they pay predictable interest and return principal at maturity, but they are deposit products, not securities. Deposits are covered by the FDIC at insured banks and the NCUA at federally insured credit unions, up to $250,000 per depositor, per institution, per ownership category. Early withdrawal usually triggers a penalty.

Preferred Stock

Preferred shares are sometimes placed in the broader fixed-income category because they usually pay a set dividend. Legally they are equity: they have no maturity in most cases, the issuer can often suspend dividends without defaulting, and preferred holders rank behind bondholders in bankruptcy.

Fixed-Rate vs. Floating-Rate Instruments

A fixed-rate bond pays the same coupon rate for its entire life. A floating-rate (variable-rate) bond resets its coupon periodically, usually as a benchmark rate plus a fixed spread. Hypothetical example: a floater paying a benchmark plus 1% would pay 5% when the benchmark is 4% and 6% when it rises to 5%. Because its coupon follows the market, a floater’s price is much less sensitive to rate changes than a fixed-rate bond’s, but its income is less predictable.

How to Invest in Fixed Income

Investors can hold fixed income directly or through pooled funds, and the choice changes how the investment behaves.

1. Individual bonds and CDs. Treasuries can be bought at auction through TreasuryDirect. Brokerage accounts generally provide access to Treasuries, corporate bonds and munis, both new issues and secondary-market trades. An individual bond held to maturity returns its face value if the issuer pays, regardless of price swings along the way.
2. Bond mutual funds. A professionally managed pool of many bonds, priced once a day at net asset value (NAV).
3. Bond ETFs. Fixed-income exchange-traded funds trade throughout the day and can target a slice of the market, such as short-term Treasuries, a credit rating band or a duration range. Like mutual funds, they charge an expense ratio.

The key distinction: a bond fund has no maturity date. It continually buys and sells bonds to keep its target profile, so there is no date on which the investor is promised the original principal back. A fund’s share price moves with rates and credit conditions indefinitely, whereas an individual bond’s price converges toward par as maturity approaches.

Bond Laddering

A ladder spreads money across bonds or CDs that mature at staggered dates, then reinvests each maturing piece at the far end.

Hypothetical example. An investor divides $60,000 into three $20,000 pieces maturing in one, two and three years. When the one-year bond matures, its $20,000 is reinvested in a new three-year bond, and the next year the same happens with the original two-year bond. A predictable share of principal comes due each year, interest arrives regularly, and if rates have risen, part of the portfolio is reinvested at higher rates. The trade-off is that if rates have fallen, maturing principal is reinvested at lower rates.

Why Fixed Income Matters in a Portfolio

Predictable cash flow. Scheduled payments let investors match income to known future expenses, which is why fixed income features heavily in retirement portfolios and in liability-matching strategies used by pension funds and insurers.

Diversification. Stocks offer higher potential returns with larger price swings; high-quality bonds generally offer lower returns with smaller swings, and their interest can partly offset stock losses. The split depends on goals, time horizon and risk tolerance. A conservative investor typically holds more fixed income; a 50/50 stock and bond mix is one common illustration of a balanced allocation.

Priority of claims. In a bankruptcy or liquidation, bondholders are paid before preferred and common shareholders. Secured bonds, backed by specific assets, rank ahead of unsecured ones.

Backing and protections. Treasuries carry the backing of the U.S. government. CDs carry FDIC or NCUA insurance within the limits above. Securities held at a brokerage firm are covered by SIPC up to $500,000 (including up to $250,000 for cash) if the firm itself fails; SIPC does not protect against a fall in a bond’s market value or an issuer’s default.

Limitations and Risks of Fixed Income

Fixed income is often described as conservative, but every type carries at least one of these risks:

• Credit and default risk. The issuer may miss interest or principal payments, and a rating downgrade can cut a bond’s price before any default happens.
• Interest-rate risk. Rising rates push down the price of existing fixed-rate bonds. This matters most to anyone who may need to sell before maturity, and to bond fund holders, who have no maturity date to wait for.
• Inflation risk. Fixed payments buy less as prices rise. If a bond pays 3% while inflation runs at 4%, the real (inflation-adjusted) return is about −1%. Inflation can also push interest rates up, which lowers bond prices.
• Reinvestment risk. Coupons and maturing principal may have to be reinvested at lower rates than the original investment earned.
• Call risk. A callable bond is most likely to be redeemed early when rates have fallen, so the investor gets principal back just when reinvestment options are worse.
• Liquidity risk. Many corporate and municipal issues trade infrequently, so selling quickly may mean accepting a lower price. Treasuries are among the most actively traded securities.
• Lower long-run return potential. Over long horizons, high-quality bonds have generally returned less than stocks, which is the cost of their lower volatility.

Analyzing a Fixed-Income Investment

Fixed-income analysis weighs a security’s expected return against what could go wrong, across these factors:

• Yield: the return at today’s price, measured as current yield or yield to maturity.
• Credit quality: the issuer’s rating and how likely it is to pay.
• Maturity and duration: how long money is committed and how far the price would move if rates changed.
• Liquidity: whether it could be sold at a fair price before maturity.
• Taxes: whether interest is taxed federally, by the state, both or neither. A tax-exempt muni yield is often compared with a taxable yield using tax-equivalent yield = muni yield ÷ (1 − marginal tax rate).
• Call and other features: whether the issuer can repay early, convert the bond or change the coupon.

Hypothetical example of the tax comparison: a muni yielding 3% for an investor in a 32% federal bracket has a tax-equivalent yield of 3% ÷ 0.68 ≈ 4.41%, ignoring state taxes.

A bond’s fair price is the present value of its remaining coupons and principal, discounted at the yield the market demands for that issuer and maturity. Higher demanded yields mean lower present values, which is the price and rate relationship expressed as a formula.

Fixed Income vs. Equity

What Fixed Income Is Not

• Not a fixed price. The payment terms are fixed; the market value is not. A bond bought at par can trade well below par for years if rates rise.
• Not guaranteed income. Payments are contractual, not guaranteed, except where a government backs the issuer or deposit insurance applies.
• Not the same as fixed-income securities. Securities are tradable debt instruments such as bonds, notes, bills and commercial paper. The broader category also includes CDs, which are bank deposits, and sometimes preferred stock, which is equity.
• Not always fixed-rate. Floating-rate notes, TIPS and other inflation-linked bonds belong to the category even though their payments change.

The Bottom Line

Fixed income matters most to investors who need predictable cash flow, such as retirees, or who want to offset stock swings in a portfolio. Only the payment terms are fixed, so prices still fall when rates rise and issuers can still default. Investors who may need to sell early, or who hold bond funds with no maturity date, should weigh interest-rate, credit, inflation and liquidity risk before choosing a product.