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Fixed income exchange-traded funds are baskets of fixed income investments that trade as a single unit throughout the day –

A money market fund is a type of fixed income mutual fund that invests in debt securities that are characterized by their short maturities and minimal credit risk. For money market funds, income can be either taxable or tax exempt, depending on the types of securities in which the fund invests. These may include short-term U.S. Treasury securities, federal agency notes, Eurodollar deposits, repurchase agreements, certificates of deposit, corporate commercial paper; or obligations of states, cities, or other types of municipal agencies.

Bond funds are professionally managed portfolios that invest in individual fixed income securities. Reasons to consider bond funds –

a. Potential for capital preservation, depending on the fund

b. Income generation

c. Diversification for a potential hedge against stock market volatility

d. Liquidity

e. Funds are guided by a stated objective, generally focusing on a particular sector, such as corporate or Treasury bonds; a broad category, such as investment grade or high yield securities; or a specific time horizon, such as short-, intermediate-, or long-term bonds.

A bond is an interest-bearing security that obligates the issuer to pay the bondholder a specified sum of money, usually at specific intervals, known as a coupon, and to repay the principal amount of the loan at maturity. Zero-coupon bonds pay both the imputed interest and the principal at maturity.

Risks Associated with Fixed Income

Credit and Default Risk

As mentioned earlier, Treasurys and CDs have protection through the government and Corporate debt, while less secure still ranks higher for repayment than do shareholders. When choosing an investment take care to look at the credit rating of the bond and the underlying company. Bonds with ratings below BBB are of low quality and consider junk bonds. The credit risk linked to a corporation can have varying effects on the valuations of the fixed-income instrument leading up to its maturity. If a company is struggling, the prices of its bonds on the secondary market might decline in value. If an investor tries to sell a bond of a struggling company, the bond might sell for less than the face or par value.

Also, the bond may become difficult for investors to sell in the open market at a fair price or at all because there’s no demand for it. The prices of bonds can increase and decrease over the life of the bond. If the investor holds the bond until its maturity, the price movements are immaterial since the investor will be paid the face value of the bond upon maturity. However, if the bondholder sells the bond before its maturity through a broker or financial institution, the investor will receive the current market price at the time of the sale. The selling price could result in a gain or loss on the investment depending on the underlying corporation, the coupon interest rate, and the current market interest rate.

Interest Rate Risk

Fixed-income investors might face interest rate risk. This risk happens in an environment where market interest rates are rising, and the rate paid by the bond falls behind. In this case, the bond would lose value in the secondary bond market. Also, the investor’s capital is tied up in the investment, and they cannot put it to work earning higher income without taking an initial loss. For example, if an investor purchased a 2-year bond paying 2.5 percent per year and interest rates for 2-year bonds jumped to 5 percent, the investor is locked in at 2.5 percent. For better or worse, investors holding fixed-income products receive their fixed rate regardless of where interest rates move in the market.

Inflationary Risks

Inflationary risk is also a danger to fixed income investors. The pace at which prices rise in the economy is called inflation. If prices rise or inflation increases, it eats into the gains of fixed income securities. For example, if fixed-rate debt security pays a 2 percent return and inflation rises by 1.5 percent, the investor loses out, earning only a 0.5 percent return in real terms.

Pros & Cons

Pros

1. Steady income stream

2. More stable returns than stocks

3. Higher claim to the assets in bankruptcies

4. Government and FDIC backing on some

Cons

1. Returns are lower than other investments

2. Credit and default risk exposure

3. Susceptible to interest rate risk

4. Sensitive to Inflationary risk

Example of Fixed Income

To illustrate, let’s say PepsiCo floats a fixed-income bond issue for a new bottling plant in Argentina. The issued 5 percent bond is available at face value of 1,000 dollars each and is due to mature in five years. The company plans to use proceeds from the new plant to repay the debt. You purchase 10 bonds costing a total of 10,000 dollars and will receive 500 dollars in interest payments each year for five years that is – 0.05 x 10,000 = 500. The interest amount is fixed and gives you a steady income. The company receives the 10,000 dollars and uses the funds to build the overseas plant. Upon maturity in five years, the company pays back the principal amount of 10,000 dollars to the investor who earned a total of 2,500 dollars in interest over the five years 500 x five years.