A MOMENT OF CLARITY
Types of Fixed Income
Chances are that fixed income (bonds) will comprise some portion of your investment portfolio during your lifetime. Many investors use bonds as safe-haven assets in their portfolios due to their (typically) lower risk level relative to stocks. However, the types of fixed income you choose can have a material impact on the performance and risk profile of your portfolio. It is important to know the different types of fixed income available, so you choose the correct type for your circumstances.
The main factors to consider when choosing which type of fixed income is right for your portfolio is, “who are you lending your money to and for how long?” Fixed income at its core is lending money to a borrower with expectations of receiving this money back at some point in the future and receiving interest payments in the interim. (These interest payments are also known as a bond’s “yield.”) If there is a very high certainty that the money borrowed will be returned and interest payments will be made on time and in full, it can be an attractive way to generate yield while maintaining stable value within your portfolio. However, if there is more uncertainty around repayment and interest payments due to the credit worthiness of the borrower and the term of the loan, there may be less stability in the bond price, but this generally means being able to collect a greater interest payment.
Who are you lending your money to?
Perhaps the most recognized type of fixed income is a “Treasury Bond.” These are bonds issued by the United States Government and they are generally viewed by the market to be “risk-free” as the risk that the U.S. Government will not repay the debt or skip interest payments is negligible. Other countries across the globe also rely on borrowing money but not all countries are risk-free. Risks can be low for countries like Switzerland or higher for countries like Brazil or Turkey. The debt of other global governments is sometimes referred to as “Sovereign Bonds.”
In addition to the federal government borrowing money, state and local governments also borrow money for various reasons. These bonds are referred to as “Municipal Bonds” and can range from very high-quality bonds with limited risk like those issued from a growing state like Texas, or they can be higher risk if they are from a small town in rural America that may be reliant on the coal industry. The benefit of municipal bonds is that the interest payments are generally exempt from Federal income taxes and in the case of bonds of your home state, exempt from state income tax as well
Companies also borrow money to grow their businesses and these types of bonds are called “Corporate Bonds.” Although corporate bonds are generally considered “riskier” from a repayment perspective than bonds issued by the U.S. Government, the risk level can range from relatively low for a large, multi-national technology company like Apple to very high for a small oil driller focused in South Dakota. Companies with strong prospects of repaying their debt and maintaining interest payments are considered “Investment Grade Corporate Bonds,” while those with considerably less certainty are considered “High Yield Corporate Bonds” (with the riskiest bonds also known as “Junk Bonds”).
How long you are lending your money out?
In addition to considering who you are lending money to, the other important factor to consider is how long you are willing to lend the money, which is referred to as the maturity of a bond. Shorter maturity bonds are generally perceived to have less risk as there is more clarity on the risk of not receiving interest payments or your money back. As such, in a normal interest rate environment, a bond with a maturity of five years will generally have a lower yield than a bond with a maturity of 20 years or more. Fixed income markets have generalized maturities into three main buckets: short-term (maturities ranging from 1-5 years), intermediate-term (maturities ranging from 5-15 years) and long-term (maturities of 15 years or more).
What bonds should you include in your portfolio?
When factoring in the different types of fixed income and the different maturities available in each, the options for your portfolio may seem overwhelming and you may be wondering which types of bonds are best for your portfolio. The answer to that question is dependent on your individual situation and market conditions. Factors such as your risk tolerance, goals and tax situation all will impact which bonds may be best for your portfolio. In addition, market conditions and the interest rates available in each type of bond and maturity also need to be considered. Understanding these different types can help you ensure that the risk level of the fixed income within your portfolio matches your needs and expectations. Contact a Round Table Wealth Advisor to discuss the appropriate fixed income allocation for your portfolio.