Beginner’s Guide: Understanding the Basics of Fixed Income Investing

As a young investor, you will likely favor a stock-focused portfolio to take advantage of higher growth potential, despite the added risk. With many more years ahead of you, this makes perfect sense. But it’s also important to consider fixed income investments like bonds and evaluate your exposure to stock market volatility and downturns. 

Maybe the idea of a bond investment conjures up thoughts of older investors, and certainly bonds can help retirees generate income when they no longer have a paycheck. But they also play a role in preserving money by reducing risk through diversification, though they can have a downside, including interest rate risk.

“It’s important to diversify early on,” said Craig Laffman, director, fixed income trading & syndicate, TD Ameritrade. One way to diversify is by investing in stocks and bonds—two asset classes that tend to respond differently to market events. This can help reduce volatility and help manage the risk of losses during bear markets.

Bonds are often less volatile than stocks. In addition, bonds sometimes outperform stocks when a bear market hits, providing protection for investors who put together more balanced portfolios. While you don’t necessarily need to devote a huge portion of your portfolio to bonds as a young investor, you might want to consider having at least a small amount of assets in bonds and accept a lower potential return in hopes of more stable growth over time. All this is really a fancy way of re-stating that old warning about not putting all your eggs in one basket.

Port in a Storm

Younger investors might not remember what it’s like to live through a major stock market slide like the one that took the S&P 500 Index (SPX) down about 50% between 2007 and 2009. 

Those were uncertain times for the stock market. If you had an all-stock portfolio of $100,000 going into late 2007, your investments conceivably would have fallen to just $50,000 at the depths of the financial crisis. In the meantime, however, because bond prices actually rose in 2008, keeping a percentage of your portfolio in the fixed income market would likely have managed this risk to some degree. Many investors with more balanced portfolios lost far less than 50% during that period. A loss of 20% might not sound too great, but it’s certainly better than losing 40% or 50%.

The stock market collapse a decade ago underscores the importance of considering fixed income in a portfolio.

“I think that we can never be confident that there won't be another financial crisis,” Fed Chair Janet Yellen told Congress last month.

“People invest in fixed income to add some stability, and with all the news across the geopolitical environment, people of any age should be concerned about the market implications,” said Matt Sadowsky, director of retirement and annuities at TD Ameritrade. “There’s the possibility of a new Fed chair, new legislation, and new regulations. By having fixed income, you’re dampening volatility and dampening the impact a down market could have.”

Of course, this does include a reduced return potential over time compared to an all-stock portfolio.

Learning the Fixed Income Types: A Lesson in Maturity?

Different types of fixed income investments include:

• U.S. Treasury bonds, notes, and bills: U.S. Treasury securities are debt obligations issued by the U.S. government to support the day-to-day operations of the federal government and to finance the national debt.
• Municipal bonds: Municipal bonds are interest-bearing debt obligations issued by a state, state agency or authority, or a political subdivision such as a county, city, town, or village to fund public projects.
• Corporate bonds: Corporate notes are fixed-rate, unsecured debt obligations from a variety of issuers with maturities ranging from short-term to long-term.

A bond is essentially a loan given to a company or a government by an investor. By issuing a bond, a company or government borrows money from investors and then pays them interest on the loan. Companies and governments issue bonds frequently to fund new projects or for ongoing expenses. 

Fixed Income Doesn’t Mean Risk-Free

For a basic lesson on bonds, here’s a video that explains exactly what they are and how they work, as well as the different types.

As the video notes, bonds do come with their own risk, including the possibility that the bond issuer might default, although that’s a rare occurrence with investment-grade bond investments. The average investor often avoids riskier-grade, or "junk" bonds.

When considering a bond, remember to do your research. Check what the ratings agencies have to say about it, which is how investors measure the risk of default. Another risk of bonds is that interest rates might rise, driving bond prices down, meaning you could lose money if you sell before the bond’s maturity date.

Although there’s no such thing as an investment without risk, fixed income investments have the potential to be less risky than stocks and can sometimes serve as an umbrella in any sort of storm that might sweep through the equity markets, whether it’s a financial crisis like 10 years ago or some sort of geopolitical turmoil. That’s why younger investors, not just retirees, should consider learning about and investing in fixed income.