When you start investing, the goal is usually to grow your wealth over time. But there will come a point when — usually during retirement — you’ll likely want to use your investments to generate income.
One way of generating income from your portfolio is to sell or liquidate assets. While this can indeed generate income, it does so at the expense of capital. By selling your assets and withdrawing the proceeds from your portfolio, you effectively shrink your portfolio over time and run the risk of outliving your savings.
The good news is that there are other means of generating income from your investment portfolio. One such strategy is known as fixed income investing.
Below, we define fixed income investing and review the types of securities that are generally considered to be fixed income securities. We also answer common questions about fixed income investing.
What is fixed income investing?
Fixed income investing is an investment strategy in which the primary goal is the generation of consistent income. It involves holding certain types of investment assets, often called fixed income securities, that generate income on a regular and recurring schedule in the form of interest or dividend payments.
Fixed income securities
When people talk about fixed income securities, they are usually talking about bonds and bond funds. Fixed income is sometimes also used to describe financial accounts like certificates of deposit (CDs) and money market funds.
Bonds are essentially a loan that you, the investor, make to a borrower — whether that be a government or corporation. In exchange for that loan, you will receive regular interest payments (known as coupon payments) at an agreed-upon yield (interest rate) until the bond matures, at which point you will receive back your original principal. Some types of bonds can also be called early, meaning you will get your principal back prior to the time expected and then no additional coupon payments.
The three main types of bonds are government bonds (Treasurys), municipal bonds and corporate bonds, each of which carries its own level of risk. Generally, government and municipal bonds are considered less risky than corporate bonds.
Certain types of funds, such as bond funds and money market funds, are also fixed income securities.
Bond funds are simply mutual funds that invest in many different bonds. They can be an excellent way of diversifying your fixed income investments.
Bond funds can be structured in several different ways. They may, for example, focus on a particular type of bond, such as government versus corporate debt. Alternatively, they may focus on a particular time frame — for example, short-term versus long-term bonds. They may also hold a wide variety of bond types and maturities.
Money market funds are a type of fund that holds short-term government debt securities, like bonds, which mature in a year or less. They are considered less risky than bond funds, but for that reason also typically carry a lower yield.
Certificates of Deposit
Certificates of deposit (CDs) are a type of fixed income security offered by banks and other financial institutions. In exchange for agreeing to keep your money deposited with the financial institution for a set term (usually three months, six months, one year, three years, or five years), you receive a higher yield on your savings than you would from the typical savings account.
CDs issued by banks are FDIC-insured, and you are guaranteed to receive your full principal back upon maturity. If you withdraw your principal before the end of the term, you will usually be required to pay a penalty, often in the form of forfeited interest.
An annuity is, in essence, a contract between you and an insurance company. Fixed income annuities, specifically, are designed to pay you a guaranteed1 level of income during retirement. This income stream will remain consistent regardless of how the market is performing or how long you live, making them an excellent source of income in retirement that you can’t outlive.
Income annuities are usually purchased with a lump sum as you approach retirement age.
Are dividend stocks fixed income securities?
No. While dividend-paying stocks can be a great way of generating income in an investment portfolio, they are generally not considered fixed income securities.
That’s because dividend payments are not “fixed” in the same way as interest payments made by securities such as the ones above. A company may choose to cut its dividend payment for any number of reasons, such as a period of low profits or constrained cash flow.
Additionally, the value of stocks (including dividend-paying stocks) can fluctuate substantially over time. This may lead to a loss of capital. While bond prices do fluctuate, bonds have a maturity date when you can expect to receive your principal back.
While dividend paying stocks can play an important role in a portfolio, they are not fixed income investments.
Pros and cons of fixed income investments
Fixed income investments can be a great addition to your portfolio, but it’s important to understand the pros and cons before you start investing.
Benefits of fixed income investments
Generally, fixed income investments offer investors the following benefits:
- Diversification. Investing in fixed income securities like bonds and CDs helps you add diversification to your portfolio.
- Income generation. Fixed income investments can offer investors a reliable flow of income.
- Capital preservation. Because fixed income investments do not require you to sell assets in order to generate income, they effectively allow you to preserve your capital.
- Lower risk of loss. While there is always some risk involved in investing, fixed income securities with high credit quality ratings typically carry a lower risk of loss of principal compared to other securities such as stocks.
- Tax benefits. Some fixed income securities may receive preferential tax treatment, allowing you to increase your tax efficiency. Municipal bonds, for example, may be exempt from federal and state income taxes.
Drawbacks of fixed income investments
The main drawbacks of fixed income investments include:
- Lower opportunity for growth. Generally, fixed income securities offer a much lower opportunity for growth compared with other types of securities such as stocks.
- May not match inflation. Depending on the yield, the income you generate through fixed income investing may or may not keep pace with inflation.
- Interest rate risk. Bonds are particularly sensitive to interest rate risk. As rates rise, bond prices usually fall. While this is not a cause for concern if you hold your bonds until maturity, if you wish to sell them ahead of schedule it may lead to a loss of capital.
- Prepayment risk. When the borrower returns the principal to you early, they no longer have to make interest payments on that principal. You, as the investor, must then reinvest the principal at the current market rate which may result in lower interest payments going forward because borrows are more likely to prepay or refinance when interest rates are lower.
Alternatives to fixed income investing
While fixed income investing can play an important role in your portfolio, it’s typically only one element of a well-diversified financial plan. In many cases, it’s important to keep some money in stocks for growth over time. In addition, some investors like to include hard assets like real estate or a real estate investment trust (REIT) as part of their overall portfolio.
Is fixed income investing right for you?
If you are interested in generating income from your investment portfolio, then fixed income investing offers you one way to do that. If you’re younger and looking to grow your portfolio over time, you may want to lean more heavily on stocks and shift some more of your portfolio to fixed income later depending on your risk tolerance.
No matter your situation, there’s a good chance that including at least some fixed income investments may make sense for you. A financial advisor can work with you to understand your goals and then tailor a plan with a range of financial options (including fixed income investments) to help you feel confident you’ll be able to do the things you want, when you want to do them.
1All guarantees are backed solely by the claims-paying ability of the insurer.
All investments carry some level of risk including the potential loss of all money invested. No investment strategy, including diversification or strategic asset allocation, can guarantee a profit or protect against loss. You should carefully consider risks with fixed income securities such as bonds, these include: Interest rate, Duration, Credit, Default, Liquidity and Inflation. Interest rates and bond prices tend to move in opposite directions, for example when interest rates fall, bond prices typically rise. This also holds true for bond mutual funds. A low interest rate environment may cause losses to bond prices and bond funds you own or in the market. Interest rates in the United States have been at, or near historic lows, which may increase a Fund’s exposure to risks associated with rising rates. High yield (Junk) bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds.
This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.