What is a fixed-income investment?
Bonds are stable assets that offer income and a lower amount of volatility compared to stocks. The yields provided by corporate and government bonds such as U.S. Treasurys and municipal bonds are currently low because the Federal Reserve lowered interest rates for an extended period. As investors reach their retirement age, they seek to generate more income and avoid volatility from the stock market and economy. They can add a mix of individual bonds, mutual funds or exchange-traded funds to their portfolio. Fixed-income investments such as intermediate- or longer-term bond funds are still providing a decent yield despite the low interest rate environment, says Daren Blonski, managing principal of Sonoma Wealth Advisors. “Investors are finding it more challenging to find yield and protect potential downside risk with fixed-income investments,” he says. Here are seven types of fixed-income investments.
Bond ETFs and mutual funds
Choosing a single government or corporate bond can be risky and more expensive. Investors tend to pay a “massive” premium when they purchase individual bonds, but portfolio managers of bond mutual funds and ETFs receive a discount for buying a large number of bonds, Blonski says. Adding an ETF or mutual fund that owns many bonds, such as the Vanguard Long-Term Bond ETF (ticker: BLV), also diversifies risk. Investors receive a broader exposure with an ETF like the Hartford Total Return Bond ETF (HTRB), he says. The fund is managed by Wellington Management Company, an investment management firm whose portfolio managers have a long track record. The fund has an expense ratio of 0.3%, with a one-year return of 7.98% and a three-year return of 5.67%. “In this interest rate environment you have to be flexible, and this ETF allows the portfolio managers more flexibility to find assets with the best possible return,” Blonski says.
Government and corporate bonds have maturity dates that range from one year to 30 years. Issuers pay the principal or face value of the bond when a bond matures. Investors receive lower yields for shorter maturities in Treasury notes because there is less interest rate risk and higher liquidity. The yield for the JPMorgan Ultra-Short Income ETF (JPST) is 1.85% year to date and 2.48% for the past year, but it’s higher than certificates of deposit yielding 0.6%. “It is better for investors to be liquid than to tie up their money in a CD,” Blonski says. “This bond fund is going to give you liquidity.” Longer-duration bonds are more exposed to interest rate moves and additional risk, says Mike Loewengart, managing director, investment strategy at E-Trade. “While short-term bonds can hedge against interest rate risk, you have to stay on your toes when you’re managing on your own.”
Preferred stocks, which are impacted by interest rates, are a hybrid investment that contain characteristics of common stocks and bonds. Investors receive a coupon that indicates the yield, says Rohan Reddy, a research analyst at Global X ETFs. When interest rates fall, preferred equities will increase in value and still provide consistent dividend payments. Preferred equities are often issued by insurance companies and banks. Investors who are planning to retire often turn to preferred stock because the yield can be higher than many bonds, Reddy says. The favorable tax treatment is a bonus since a “decent portion” of the dividends of preferred stock are classified as qualified dividends and are taxed at the long-term capital gains rate.
High-yield bonds are riskier. In return, they provide a higher yield. In this current market environment with interest rates on higher-quality assets at historic lows, some investors “may be drawn to high yield in search of income they can’t find elsewhere,” says Jodie Gunzberg, managing director, chief investment strategist at Morgan Stanley, Wealth Management Institutional. High-yield bonds may be an attractive investment since they offer a competitive expected rate of return to parts of the equity market with lower expected volatility, she says. “High-yield bonds are trading at historically low levels of absolute yield, so investors aren’t necessarily getting compensated for the risks of investing in high yield,” Gunzberg says. “Many issuers of bonds in the high-yield market are from industries that are facing material disruptions to their business models that they may not recover from fast enough to avoid default.”
Municipal bonds are issued by government entities such as a city, state or an agency. The issuer pays the face value of the bond when it matures along with interest. Depending on where you live, municipal bonds are tax-free, and allocating them in a brokerage account can make more sense for tax consequences. Investing in a municipal bond mutual fund or ETF will lower the risk of investing in a specific city or state. “The municipal bond market is highly inefficient because it’s dominated by smaller investors,” says Michael Underhill, chief investment officer of Capital Innovations. “Investing in an ETF means a lower entry price for investors.”
Corporate bonds provide investors with yield and a return of the principal amount. Investors should stick with bonds that have an investment-grade rating, such as AAA, but no lower than BBB. Investing in corporate bonds allows an investor to receive additional income for taking on credit risk, Gunzberg says. “With corporate balance sheets largely in good shape despite increasing leverage over the past few years, risks of large-scale credit issues are low,” she says. “Given the low coupons that many investment-grade bonds have been issued at, durations or interest rate risk for these bonds is significantly higher than in the past. This further adds to the risk of loss should rates rise, similar to other asset classes.” While the market is near a record low interest rate environment, there are still opportunities for protection, Loewengart says. “Highly-rated corporates is one area of the bond market that may provide a higher yield than government bonds, while still maintaining a level of safety,” he says.
Treasurys and municipal bonds make up government bonds, but they are impacted more by potential interest rate drops. Investors who own bonds that mature in 15 or 30 years face the most risk. Investors must consider the potential for default before adding city or state bonds to a portfolio. “Treasurys are relatively less risky than other bond options because technically they are backed by the U.S. printing press. However, moving forward, they are likely to offer the investor less yield,” Blonski says. Adding government bonds will preserve capital and investors will benefit from “a belief that rates will move even lower from a faltering economy,” Gunzberg says. “These come at a cost since there is little to no income to be realized, and the upside potential from price appreciation is limited in many parts of the market given the Fed view that a negative interest rate policy is not an effective tool.”
Seven types of fixed-income investments:
— Bond ETFs and mutual funds.
— Short-term bonds.
— Preferred stock.
— High-yield bond funds.
— Municipal bonds.
— Corporate bonds.
— Government bonds.
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Update 10/27/20: This story was published on a previous date and has been updated with new information.