Last week, I started the Asset Allocation Basis series with a general definition of asset allocation and the different asset classes. Today, we will be reviewing the fixed income asset class. Regardless if you are ready to take risk or not, fixed income should always be considered while managing your asset allocation as a new or experienced investor.
What is the point of having fixed income in my portfolio?
Fixed income assets are the “safest” investments you can have in your portfolio. However, there are very safe fixed income products and very volatile ones as well. Fixed income usually provide regular interest or dividend revenue as they are considered as “debt” for the other party (the entity you are buying it from). This is why we call them “fixed” income; because they provide a determined source of income. However, depending on the issuer, your fixed income may default and not pay your income… as any other debt payer
Different asset classes considered as fixed income
This is considered to be the safest investment possible (depends whether you are buying US bonds or Greek bonds!). Since they are guaranteed by a country, investors tend to give them a high credit rating (then again, it depends on the country).
State or provincial bonds are issued by the second level of government of a country. For example, you can buy California bonds. Since the state is usually not as strong as the country, you should benefit from a higher investment rate of return.
This is the last level of government bonds on the market. I particularly like municipal bonds as they are not very risky but still pay a premium compared to state or government bonds. They are also easy to sell on the secondary market.
Certificate of Deposits
Certificate of deposits are issued by financial institutions. If you are living in the states, they are not only guaranteed by the bank but also by the FDIC up to $250,000. These institutions usually give a higher rate then the 3 above mentioned fixed income products but they cannot be redeemed until maturity. Therefore, if you are not sure that you will need the money or not before it matures, you are better off with bonds than CDs.
Just as governments can issue debt to be bought by investors, corporations also have the right to ask investors to lend them money in exchange of a repayment with a fixed interest rate. Depending on the quality of the company (i.e. chances of being paid back by the corporation), you can earn a pretty decent interest rate. If the company financials are not too good and they have to pay a big premium to find investors, they fall in the next category; junk bonds.
Junk bonds are corporate bonds issued by businesses with weak financial statements. Since there is a higher risk of default, those companies have to pay a higher interest rate to attract bond holders. If they don’t, nobody will lend them the money (as you can see, this is exactly the same thing with poor credit individuals who get “B” financing).
This is the last type of fixed income asset class. Preferred shares are issued by corporations and are more volatile than bonds. The stock follow the market trends according to the financial results of the company. Preferred share holders are the first investor to receive dividends (before common shares). This is why we can still qualify them as “fixed income”. However, they are far from being secured. On the other hand, you have the possibility to receive income from the dividends and earn money from the appreciation of your shares over time.
Questions about fixed income?
Make sure to drop your comment here if you have any questions about fixed income!