Chapter 13: Fixed Income
The stock market offers a way to potentially grow your savings at a faster rate. However, this option has higher risk, especially over a short period. Instead of, or in addition to, investing in stocks you can invest in a range of fixed income options. As the name would suggest, these investments are designed to provide a more fixed—or predictable—return. They tell you up front when and how you’ll be paid back on your investment.
We mentioned in Chapter 3 that there are two main categories of investments. The first is to own, like buying a stock. The second is to lend, which is what you do with fixed income options. There are lots of fixed income options available, some of which you’re likely already familiar with. A savings account that pays interest is the simplest form of fixed income. Your financial institution tells you that each day, you’ll earn a fixed amount of interest. Another example is a guaranteed investment certificate (GIC). Financial institutions want to borrow money from you for fixed periods of time, often one to five years. If you buy a GIC, you’re lending your money for that fixed period in exchange for interest. The final option we’ll discuss is a bond.
In all these cases, the return is more predictable than higher-risk investments. If you have a long time before you need your money, you may only invest a small portion of your savings in fixed income. However, if you only have a few years to invest, or if you’d like to diversify, fixed income options are excellent.
Guaranteed Investment Certificates (GICs)
If you don’t need your money for a year or more and don’t want to invest in higher-risk options, GICs are a common choice. GICs typically require that you commit to lending your money for a fixed period. If you need your money back before the period is over, there can be penalties. Because you’re agreeing to lend for a fixed period, the borrower is often willing to pay you a higher interest rate. For instance, the interest on a savings account where you can withdraw any time may be 1.5%. However, if you commit to lending for a year through buying a one-year GIC, you may receive 2% interest. In addition, typically the longer you lend your money, the higher your return. Instead of buying a one-year GIC and earning 2%, you could buy a three-year GIC and receive 2.5% a year.
In Canada, GICs are guaranteed by the financial institution you’re buying from. In addition, if for any reason they can’t pay you back, your money may also be protected by the CDIC. The Canada Deposit Insurance Corporation (CDIC) offers insurance up to a maximum of $100,000 for certain deposits. You can speak with your financial institution or CDIC to learn more about the coverage, given your situation. Because GICs define the rate of return and period up front, they’re much more predictable than the stock market. However, the rate of return is likely to be lower than what has historically been earned in the stock market. Before purchasing a GIC, it’s important to consider two things. Check if the return is higher than a savings account by enough to justify locking in your money. Confirm if you’re in a position where you could take on more risk and potentially earn a higher return through a different option.
Bonds
Another fixed income investment option is a bond. Most people are unfamiliar with bonds, and it’s unlikely you’ll ever buy one directly. However, it’s important to understand what they are and how they work. We’ve mentioned that for most people, an easy approach to investing is to buy a fund, which we’ll cover in the next chapter. These funds typically buy bonds on your behalf for the fixed income portion of the investment.
Bonds are used by companies and governments to raise money needed to operate. The first step is for the company or government to issue the bond. This is the term used when the bond is first created. The bond is then exchanged for the loan payment from the investor. After the bond has been issued, it can be traded—or bought and sold—similarly to a share. The primary difference between a bond and a share is the amount of uncertainty to returns. As we covered previously, a share gives you ownership to a portion of a company, which has an uncertain future value. A bond, on the other hand, offers more certainty. You lend your money to a company or government today in exchange for repayment of your money plus interest in the future. The return in this case is better defined and equals the interest received over time.
Let’s think back to our snow cone stand example and consider if the boy had taken a slightly different approach. Like before, the boy asks his siblings to borrow $20 from each of them to start his stand. However, instead of offering ownership—or shares—in his business, he decides to issue a bond to each of his siblings. In exchange for the $20 today, he guarantees them $2 at the end of each month for the next four months. He also promises to return their $20 in four months’ time. In this case, the return on the siblings’ money is clear to see. By lending $20 today, the siblings stand to make $8 in interest and receive their $20 back in four months. Therefore, provided the snow cone stand can make all the scheduled payments, the siblings will earn a profit of $8 each.
Rate of Return
The return on a bond is more predictable than a stock because the payments are defined ahead of time. Bonds still carry some risk. For instance, if the company or government can’t make interest payments or return the loan, you could lose money. This can happen through poor management, unexpected economic conditions or a list of other reasons. The risk that the bond may not be repaid is what determines the return—or interest—that must be paid. The higher the risk the bond may not be paid back, the higher the return it should offer.
Bond Value
Just as the stock market offered the ability to trade shares, bonds can be purchased and sold in a similar manner. Like stocks, there are several factors used to determine the value of a bond. These include:
How much you’ll be paid, also called interest rate
This is the amount of any interest payments received each year.
When you’re paid back, also called maturity date
This is the date you receive your initial loan back.
How likely you’ll be paid, also called bond rating
This includes receiving both the interest and repayment of the original loan.
Interest Rate
The interest rate—or coupon rate—is the amount of interest received each year. Bonds may offer interest payments ranging from 0% to 5%. You may be able to find higher interest rates, but these are typically paid by lower quality bonds. The interest payment a bond offers depends on the quality and length of the loan. The higher the interest rate—if everything else is the same—the more an investor is willing to pay for a bond.
Maturity Date
The maturity date of a bond is when you receive your original loan back. Bonds can be categorized as short-term (maturing in the next three years), medium-term (maturing in four to ten years) or long-term (maturing in greater than ten years). A longer maturity bond carries greater risk due to the uncertainty that you’ll be repaid. In addition, committing to a longer period means you may miss out on other investment opportunities. As a result, long-term bonds usually offer a higher return than short-term bonds.
Bond Rating
The bond rating is the quality of the bond, or the chance that it will be repaid. The higher the quality, the lower the chance the company will default, or not pay back the loan. Bond ratings follow a grade system and range from AAA down to C or D. AAA are the highest quality—or safest—and C or D are referred to as junk bonds. These junk bonds have a higher uncertainty of repayment.
One of the main benefits of bonds is that they typically hold less risk than other investments like stocks. However, not all bonds offer this lower level of risk. Bonds that are rated below BBB are considered non-investment grade. These carry higher risk than investment grade bonds that range from AAA to BBB. As a result, it’s important to avoid non-investment grade bonds when investing for the low-risk portion of a portfolio.
The higher the rating, the more an investor is willing to pay. If a company’s bonds are downgraded from AA to A, the value of their bonds will decline. Because investors are willing to pay more for high-quality bonds, the return on these bonds is lower.
Bond Prices
Over time, like shares, bond prices fluctuate in value. Depending on the interest rate, maturity date and bond rating, a bond’s price will change due to market developments. As interest rates of equal risk investments change, the prices of all existing bonds are impacted. If the interest rate offered on new bonds decreases, the attractiveness and price of current bonds increases. These existing bonds are locked in at a higher rate of return. Therefore, they’re purchased until the expected return of all similar investments are the same. As interest rates increase, the opposite happens, and all existing bonds become less valuable. The longer the time until maturity, the more the bond price changes.
Diversification
Diversification, once again, plays an important role when purchasing bonds. To minimize the risk of losing money when buying bonds, it’s important to invest in a diverse range of them. This can be done by purchasing bonds backed by different companies and governments. It can also help to buy some bonds that mature soon and others that mature in the future. For instance, the most recent economic crisis in 2008 was partially due to a specific type of bond. These bonds were mortgage-backed securities, meaning they were used to lend to people to buy houses. The bonds were incorrectly rated as high-quality investments. This error and the resulting losses in these bonds demonstrate that diversification continues to be critical, even with fixed income investments.
Investing part of your savings in bonds, or any fixed income, can be a great way to minimize your chance of loss. Throughout history, as stocks and other investments decline in value due to uncertainty, bonds typically rise in value. Investors move their money into safer investments in times of uncertainty, which increases the price of your bonds. This allows returns on bonds to offset losses on stocks, making your returns more consistent.
Final Thoughts
We’ve now seen that returns from bonds are much more structured. These returns can often be used as a type of consistent and dependable form of income. As retirement approaches, you can invest more money in fixed income investments. This will help cover various expenses throughout retirement. Instead of selling shares to generate money for groceries and other expenses, you can use interest payments. The lower-risk and predictable income make fixed income investments desirable in the later periods of a savings plan.
Key Takeaways
Fixed income investments offer a more predictable way to grow your money, typically at a slower rate.
Diversify your savings by investing in multiple fixed income options.
Bond prices are determined by how much, when and how likely you’ll be paid by the borrower.
This blog is a duplicate of the recently self-published book The Snowman’s Guide to Personal Finance available for purchase here.