Fixed income investments have a place in most individuals' investment
portfolios. Bonds or other types of fixed income investments provide
diversification, predictable income and are generally thought of as more
conservative investments than stocks.
Different Types of bonds
Certificates of Deposit or Savings Certificates
Issued by banks, thrifts and credit unions, these instruments are probably
the easiest to buy and own. They are often available in maturities ranging
from 30 days to over five years. Since they are insured by the FDIC or NCUA
up to $100,000, the risk of default is almost nonexistent.
US Government bonds
The Federal Government also issues bonds of varying maturities. Treasury
bills are issued with maturities of less than a year. Treasury notes have
maturities from one to ten years and Treasury bonds have maturities from ten
to thirty years. US Treasury obligations are considered to be some of the
most financially sound investments available. Even though the risk of default
is negligible, the values of these bonds change as interest rates change.
When rates rise, values fall and vice versa. The longer the maturity, the
more their values will change with changing interest rates.
Municipal bonds
Most obligations issued by states, cities and other non-federal
governmental bodies pay interest that is not subject to federal income tax.
As such, the interest rates on those bonds is usually lower than similar
quality and similar maturity taxable bonds. To determine if tax-free
municipal bonds are right for you, compare the after tax yield of a similar
taxable bond with the tax-free yield of a municipal bond.
Not all tax-free bonds are of equal quality. Ratings agencies assign
quality ratings to many bond issues. They look at the credit worthiness of
the issuer and other factors. Usually it is a good idea to stay with high
quality bonds - those rated A, AA or AAA. The market values of municipal
bonds also change with changes in interest rates.
Corporate bonds
Corporations also borrow money by issuing bonds. The interest from these
bonds is fully subject to federal and state income taxes. The ratings
agencies also usually assign ratings to corporate bonds and staying with the
high quality bonds makes sense.
Ways of own bonds
Individual Bonds
You can buy individual bonds from many sources. Banks usually offer
government bonds and brokerage firms can sell all types of bonds. The biggest
benefit to owning individual bonds is the ability to choose exactly what
bonds you own. Most bonds send interest or you can have it deposited into
your brokerage account.
Mutual Funds
With a fixed income mutual fund, you buy shares in a fund that owns a
portfolio of different bonds. The bonds are selected by the portfolio manager
who also monitors the bonds while they are in the fund. The portfolio manager
has the ability to buy and sell bonds from the portfolio as he or she thinks
the market is changing. For example, if the manager believes that interest
rates are going to rise, he or she may replace longer-term bonds with shorter
maturity bonds so there will be less price deterioration if rates rise.
The disadvantages of bond mutual funds include the costs of the fund and
being subject to poor selections by the portfolio manager.
Unit Investment Trusts
Unit investment trusts (or UITs) are like a mutual fund in that you buy
into a portfolio of bonds, but the portfolio remains static. Once the UIT is
formed, the bonds stay in place until they mature. Usually the costs of a UIT
are lower than a mutual fund but you give up the close monitoring that is
part of the portfolio manager's duties with a mutual fund.
Words of Caution
Fixed income investments should be conservative tools used to lower overall
portfolio risk and to produce steady streams of income. There is often a
temptation to consider types of bonds or other fixed income investments that
offer returns that seem very high compared to the alternatives. Stay with
high quality issues bought from reputable institutions. When something seems
too good to be true, it often is.
