Investing For Your Future

Unit 5: Fixed-Income Investing

Barbara O’Neill, Ph.D., CFP, Rutgers Cooperative Extension

In unit 4, you explored characteristics of equity investments such as real estate and stock. This unit will discuss general characteristics of fixed-income securities and describe 15 specific types of these investments. There are two general categories of investments: ownership and loanership. With "ownership" assets, investors own all or part of an asset (e.g., real estate, corporation). They buy shares of company stock or growth mutual funds or, perhaps, a rental property. In other words, as an owner, they have an equity or ownership interest in a company or property, and their principal and investment earnings fluctuate with market conditions and other factors (e.g., company earnings) that affect an asset’s selling price.

Fixed-income investments, on the other hand, are "loanership" assets; investors loan their money to a government entity (e.g., state), corporation, or financial institution (e.g., bank, credit union) and receive interest on a regular basis (e.g., monthly, semi-annually). The rate of interest paid can either be fixed for the life of an investment (e.g., Treasury securities) or can fluctuate with the general movement of interest rates (e.g., series EE savings bonds). The principal (amount of original investment) is returned at maturity (the date on which principal must be repaid), although its value can fluctuate (if sold beforehand) according to changes in interest rates. For many fixed-ncome securities (e.g., bonds), as interest rates rise, asset prices decline and, as interest rates decline, asset prices rise. This inverse relationship of interest rates and asset value, called interest rate risk, affects the value of fixed-income securities if you have to sell them prior to maturity. In other words, you could lose principal if interest rates rise and you have to sell early.

Why Buy Fixed-Income Investments?

There are many reasons to consider fixed-income investments. One is that they add diversification to an investor’s portfolio. Research by several Nobel prize-winning economists found that, for every level of investment risk, there is a "best combination" of assets that produces the highest rate of return. Investing in just one asset class (e.g., stock, bonds, or cash), however, is less desirable than selecting a combination of assets because doing so increases investment risk. It’s like the old saying "don’t put all of your eggs in one basket." By combining investments that are affected differently by economic events, investment risk is reduced. While both stocks and bonds often are similarly affected by interest rates in the short run today, over the long term they have had a relatively low relationship to each other. The technical word for this is correlation, which is a statistical term that indicates the degree to which the movement of one variable (in this case, an asset class price) is related to another.

Besides diversification, there are several other reasons to consider fixed-income securities. First, they are a good option for conservative investors who are fearful of ownership assets. If the price fluctuations of the stock market are likely to cause sleepless nights, fixed-income investments like bonds are less risky because investors are less likely to lose principal. Most fixed-income securities also provide a predictable stream of income. This can be an advantage for current or near retirees who seek regular income to supplement a pension and/or Social Security.

Predictability of investment return is a third feature of fixed-income securities. The rate of return is fixed for the life of most investments and a certain amount of income can be counted upon (e.g., a 6% interest rate on a $1,000 corporate bond will pay $30 semi-annually). Some fixed-income investments also provide tax advantages. Fixed annuities, for example, are tax-deferred and municipal bond interest is federally tax-exempt. Some investments (e.g., bond funds) also allow investors to reinvest earnings, plus most fixed-income securities typically earn a higher return than bank accounts. This is especially true for substandard grade bonds rated less than Baa by Moody's or BBB by Standard & Poor's. Investment yields generally increase as the credit quality of a bond issuer drops. Thus, investors can increase their income by purchasing lower-rated bonds. Further information about bond ratings is available in many public libraries. Fixed-income securities with longer maturities (e.g., 30-year bonds) typically pay a higher interest rate than shorter-term investments (e.g., 10-year bonds) to compensate investors for having their money "tied up" for additional years and for increased exposure to price fluctuations caused by interest rate risk.

Some fixed-income securities also have capital gain (or loss) potential. Capital gains can accrue if investments are sold in secondary markets at a premium (more than their face value) prior to maturity. Gains occur when interest rates decrease and bond prices rise. A final feature of fixed-income investments is affordability. Most investment products in this category require a minimum purchase of $1,000 or less. Treasury bills and notes, for example, all require minimum initial deposits of $1,000, as do corporate bonds, unit investment trusts (UITs), and many bond mutual funds. Even among municipal bonds, which generally require $5,000, some issuers offer $100 or $500 "minibonds" that provide tax-exempt income to small investors. Ginnie Maes, which require $25,000 to purchase directly, can be bought in $1,000 units through Unit Investment Trusts (UITs). Series EE bonds can be purchased for as little as $25 and I bonds for $50.

Next, we will briefly examine 15 fixed-income investments and five general tips for fixed-income investing. The list begins with securities sold at banks, followed by various types of bonds and other fixed-income investments that are generally sold by brokers.

Certificates of Deposit (CDs)

Also known as "time deposits," certificates of deposit (CDs) are an insured bank product that pays a fixed rate of interest for a specified period of time (e.g., 18 months). Typical CD maturities range from seven days to five years, with higher rates of return paid on CDs with longer maturities. A penalty is assessed if funds are withdrawn prior to maturity, resulting in the loss of a certain number of days of interest (the amount varies among financial institutions). If an early withdrawal penalty exceeds the interest earned, the difference will be deducted from an investor’s principal.

Many people think that CDs can only be purchased at banks. Many credit unions and full-service brokerage firms also sell federally insured CDs to investors. Investment firms purchase the CDs of banks nationwide in large blocks and sell them to investors in small denominations. The difference between their buying and selling price, called "the spread," is how they make a profit. Since brokers shop the entire country for high yields, brokered CDs often pay more attractive rates than CDs at local banks. CDs can be redeemed prior to maturity, often without penalty, but, due to interest rate risk, the value of a brokered CD can be higher or lower than someone’s initial investment.

Another relatively new type of CD is the equity-indexed CD. Sold through both banks and brokers, these CDs base returns, in part, on appreciation of a stock market index like the Standard & Poor’s 500 (S&P 500). Many require a $5,000 initial investment ($2,000 for IRAs). Unfortunately, equity-indexed CDs rarely include the full appreciation potential of the S&P 500 because they exclude the portion derived from company dividends. Many also cap the maximum growth rate, which further reduces upside potential. As a result, most financial advisors suggest avoiding these CDs and buying regular CDs for income and a stock index fund for capital growth.

Series EE and Series I U.S. Bonds

U.S. savings bonds are the lowest-denomination securities issued by the Federal government. Income earned is exempt from state and local taxes. Federal taxes can be deferred for up to 30 years or until the owner cashes a bond. Both the Series EE and I bond are available at most banks and many credit unions and other financial institutions in denominations ranging from $50 to $10,000. Many employers offer both Series EE and inflation-adjusted I Bonds through convenient payroll savings plans. The purchase price of EE Bonds is one-half their face value (e.g., $50 for a $100 bond). I bonds are sold at face value in the same denominations as Series EE. The accrued interest on both series is paid when the bonds are redeemed. Bonds can be redeemed at most financial institutions.

Effective May 1, 2005, Series EE bonds pay a fixed interest rate for the life of the bond based on whatever rate is in effect at the time of purchase.  Interest rate changes are made on May 1 and November 1.  Series I Bonds earn a fixed rate over and above an inflation adjustment based upon changes in the Consumer Price Index. Interest accrues federally tax-deferred for as long as 30 years or until the bond is redeemed. Earnings on both series are subject to federal tax, but may be tax-free if cashed in a year when the owner pays qualified higher education expenses. Income limits and other restrictions apply; see IRS Form 8815 for details. Earnings from all savings bonds are exempt from state and local taxes. Current rate information can be obtained by phoning 1-800-4US-BOND (1-800-487-2663).

It is sometimes confusing to determine the current redemption value of Series EE bonds or when they have doubled in value. If interest rates are so low that a bond is not worth its face value in 17 years, the U.S. Treasury will add a one-time "make-up" to ensure that it is worth twice as much as an investor paid (e.g., $50 for a EE bond originally purchased for $25). Basic bond redemption tables are free and available at many banks or from the Bureau of the Public Debt, (see above). Another way to determine the value of a Series EE bond is to use the Savings Bond Wizard feature of the Treasury Department’s Web site: http://www.treasurydirect.gov/indiv/tools/tools_savingsbondwizard.htm. If your grandmother gave you a savings bond 20 years ago, for example, you can check a table or the Web site to find what it is worth.

Money Market Mutual Funds

Money market mutual funds are a type of mutual fund consisting of high quality, short-term debt instruments such as Treasury bills and short term corporate IOUs. Like all mutual funds, money market mutual fund (MMMF) portfolios are professionally managed and a management fee is charged against fund assets to cover this expense. MMMFs offer market-based rates and are quick to respond to changing conditions because the average maturity of securities in their portfolio is 90 days or less. The minimum initial deposit is set by individual investment firms and can range from $250 to $25,000. MMMFs can be purchased directly from investment companies or with the assistance of financial advisors.

Unlike bank-sponsored money market deposit accounts (MMDAs), there is no FDIC insurance if a MMMF fails to maintain a $1 share price. Failures have happened very infrequently in the last 20 years, however, and most investment firms have shored up MMMF prices with other company assets to avoid a loss of principal by investors. Limited check writing is generally available on MMMFs with a minimum amount (e.g., $250) per check. Investors seeking both safety of principal and tax advantages can select tax-exempt MMMFs that include short-term securities issued by state and local governments. Other conservative choices are MMMFs that invest solely in Treasury bills and/or Treasuries plus debt of federal government agencies. 

Bonds: An Overview

Before discussing various types of bonds, some background is in order. Bonds are debts or IOUs of corporations or government entities. Bond issuers promise to pay a specified rate of interest, called a coupon rate, periodically and to repay the face (a.k.a., par) value of the bond (e.g., $1,000) at maturity. Corporate and municipal bonds are typically sold by brokers, who receive a sales commission. Bonds are subject to interest rate risk. If interest rates rise, the value of previously issued bonds will drop as investors demand a price adjustment equivalent to earning the prevailing interest rate. If interest rates drop, a previously issued bond will be worth more than its face value because investors would be willing to pay a premium to obtain a bond paying more than the currently available rate. The value of long-term bonds is affected more than short-term bonds by interest rate fluctuations. Bonds are also subject to call risk. This means that a bond issuer may choose to retire existing bonds, issued when interest rates were high, and reissue them with new debt at a lower interest rate.

The capacity of bond issuers to repay their debt is rated by various commercial firms such as Moody’s and Standard & Poor’s. Bonds rated Baa to Aaa by Moody’s and BBB to AAA by Standard & Poor’s are considered investment grade. Those with lower ratings are termed substandard grade. Substandard grade bonds or bond funds can often be recognized by the words "junk" or "high yield" in their title.

U.S. Treasury Securities

There are two types of Treasury securities currently available for purchase: bills and notes. All require a $1,000 minimum deposit with larger amounts purchased in increments of $1,000. Treasury bills have the shortest term of all Treasury securities and come in 3- and 6-month maturities. They are bought at a discount with investors paying $1,000 or more up front and receiving back an amount, called "the discount," equal to the interest rate determined by the most recent auction. At maturity, an investor’s original purchase amount (principal) is returned. If interest rates are 4%, for example, an investor with $1,000 would receive a discount of $40 ($1,000 x 0.04) shortly after purchase and their $1,000 principal back at maturity.

Treasury notes currently come with 2-, 5-, and 10-year maturities. They pay a fixed rate of interest semi-annually until maturity, when investors get their principal back. For example, a $1,000, 5-year Treasury note with a 5% yield pays $25 every six months ($50 per year). The yield on Treasury notes is generally higher than that of bills to compensate for the risk of investing longer and the greater volatility that accompanies interest-rate changes.

Treasury securities can be purchased from a bank or brokerage firm for a fee of about $50 or with no fee from the Federal Reserve Bank’s "Treasury Direct" program. An application, called a tender form, is required and can be obtained by calling 202-874-4000 for a list of Federal Reserve Banks or through the Treasury Department Web site http://www.publicdebt.treas.gov/.  With Treasury Direct, an investor must specify a bank account where their interest payments can be deposited electronically. Treasury securities also can be sold through the Treasury Direct program for a nominal charge.

Municipal Bonds

Municipal bonds are debt instruments of state and local governments or government-related entities (e.g., bridge or highway authorities). General obligation (GO) bonds are backed by the full taxing ability of the issuer and are considered the safest of municipal bonds. A second type of municipal bond, the revenue bond, is backed by some type of revenue-generating source (e.g., fares, tolls, fees) and generally pays a slightly higher rate of return.

Municipal bonds are generally attractive to persons in the 25% marginal tax bracket and higher. Even though municipal bonds pay a lower return than other bonds, investors  keep more of what they earn because the interest is generally federally tax-exempt. Interest is also state tax-exempt, if bonds are issued by an investor’s state of residence. An exception is the so-called private purpose municipal bond sold to finance sports stadiums, airports, hospitals, and the like. Municipal bonds are generally sold by brokerage firms in $5,000 increments with less expensive "minibonds" requiring a lower amount (e.g., $500). Interest is paid semi-annually. Investors can also obtain the tax advantages of a municipal bond by purchasing a municipal bond mutual fund, often for an initial investment of $1,000 or less. To determine your marginal tax bracket, refer to Figure 1 in Unit 7, Tax-Deferred Investments..

Corporate Bonds

Corporate bonds are debt instruments issued by for-profit companies to raise capital for expansion and/or ongoing operations. They are generally sold in $1,000 increments and pay taxable interest twice a year. Corporate bonds generally pay higher interest rates than government bonds with comparable credit ratings and maturities. Investing in a corporation is a greater risk than a government entity that has the ability to raise revenue through taxes. Thus, investors must be compensated accordingly. The least risky of all corporate bonds is a mortgage bond because it is backed by a company’s land and buildings. Bonds backed by non-real estate assets (e.g., airplanes, securities) have more risk. The highest risk corporate bond is a debenture, which is a corporate bond backed only by a company’s future earnings and promise to repay. Conservative investors will want to select mortgage bonds issued by investment grade (i.e., highly rated) companies.

Convertible Bonds

As their name suggests, convertible bonds are a type of corporate bond that allows investors to "have their cake and eat it too," almost. They provide the upside potential of stocks (the opportunity to participate in company earnings) with the downside protection of bonds (a fixed return and repayment of principal at maturity). Convertible bonds can be exchanged for a specified number of shares of common stock of the issuing company. As the price of the company stock increases, the convertible bond price also increases because the option to convert becomes more valuable. This correlation is true whether an investor chooses to convert or not. The trade-off is that convertible bonds generally convert to fewer shares of stock than you could buy for the cost of a bond. Almost all convertible bonds are callable. Even though they are a "hybrid" investment, convertibles (like all bonds) are sensitive to interest rate fluctuations. They can be purchased as individual securities in $1,000 increments or through convertible bond mutual funds.

Zero-Coupon Bonds

As their name implies, zero-coupon bonds pay no (zero) annual interest. Instead, they are sold at a deep discount and eventually grow to full face value ($1,000). An investor might pay only $200 or $300, for example, for a bond that matures in 15 or 20 years. Brokers may require a $5,000 purchase, however, or five times the initial cost. For example, an 8% zero-coupon bond with 15 years to maturity would cost $308. To purchase five such bonds ($5,000 face value) would cost $1,540 (5 x $308). So, in this example, if you invest $1,540 now, you know you'll get back $5,000 in 15 years. This return might be suitable for a goal you want to achieve in 15 years (e.g., future education expenses of a young child).

Many investors like zero-coupon bonds for their relatively low upfront cost and predictability. An investor knows exactly how much they’ll have at maturity. Two disadvantages of zero-coupon bonds are their extreme volatility with interest rate changes and the fact that annual increases in value are considered taxable income. Immediate taxation can be avoided, however, by using zero-coupon bonds for tax-deferred retirement plans, such as IRAs, or by buying tax-exempt (e.g., municipal) zero-coupon municipal bonds.

Unit Investment Trusts

Unit Investment Trusts (UITs) are a professionally selected portfolio of similar securities (e.g., 30-year municipal bonds) packaged together and sold by brokerage firms. Unlike mutual funds, UITs are a "buy and hold" investment, and there is no ongoing portfolio management. UIT sponsors simply buy a collection of bonds (and, with some UITs, stocks) and hold them. Investors receive periodic interest payments and a return of principal at maturity. If bonds within a UIT portfolio are sold or called prior to maturity, some principal may be returned sooner.

UITs are generally sold in $1,000 increments called units. The interest earned is taxable unless a UIT invests in tax-exempt bonds. If an investor needs his/her money prior to maturity, units can be redeemed at their current market value, subject to interest rate risk. Two advantages of UITs are broad diversification and steady cash flow. A specified rate of return is locked in for the duration of a UIT. Two disadvantages are high upfront costs (typically a 3% to 5% sales charge) and the potential for loss if units are sold prior to maturity. For some UITs, selling units prior to maturity may be difficult or costly because secondary markets are small. For more information on UITs, see Unit 8.

Bond Mutual Funds

Instead of purchasing individual securities, an investor might decide to purchase shares of a bond mutual fund. Advantages include broad diversification, liquidity, and ongoing professional management. In addition, bond fund accounts can sometimes be opened for $500 or less, making them attractive for persons with small dollar amounts to invest. The biggest disadvantage of bond mutual funds is that, unlike individual securities and UITs, there is no fixed maturity date. Thus, the price of shares is always subject to fluctuation with changes in interest rates, and an investor could lose principal if interest rates increase. As with all mutual funds, the key factors to look for when selecting a bond fund are historical performance and expenses. Unlike stock funds, that have the potential for capital appreciation to offset fund expenses, bond funds must rely on low management costs to enhance their returns. In addition, bond funds generally invest in similar securities (e.g., Treasuries), so most of the difference in return among bond funds is due to differences in cost. The average annual expense ratio (expenses as a percentage of fund assets) for bond funds is about 1% ($1 for every $100 invested), but there are some low-cost fund families like Vanguard, T.Rowe Price, TIAA-CREF, and Fidelity that charge significantly less.

A 1997 study of bond mutual funds by Consumer Reports magazine found that, among government bond funds, funds with low expense ratios outperformed their peers. One low-cost bond mutual fund is a bond index fund. Bond index funds purchase the same securities that comprise a benchmark bond index, such as the Lehman Brothers Aggregate. Since the portfolio of securities is pre-determined by whatever bonds comprise an index, trading costs are minimal and bond index fund management expenses are low. Like individual bonds, bond funds with the longest maturities are extremely volatile when interest rates fluctuate. Conservative investors should select short-term bond funds consisting of investment grade securities.

Mortgage-Backed Securities

Mortgage-backed securities are investments in a portfolio of home mortgages and are sometimes referred to as "pass-through" securities because homeowners’ mortgage principal and interest payments are "passed through" to investors. The most well-known mortgage-backed security is the Ginnie Mae, which is issued by the Government National Mortgage Association (GNMA). Ginnie Maes carry the "full faith and credit" guarantee of the federal government.  Ginnie Maes require a $25,000 minimum purchase, with $5,000 increments, from brokers, but can also be purchased indirectly for $1,000 through units in a Ginnie Mae unit investment trust. They can also be purchased through mutual funds that invest in U.S. government agency securities (minimum amounts vary per fund).

Two other mortgage-backed securities that are not backed by the federal government are Freddie Macs, issued by the Federal Home Loan Mortgage Corporation (FHLMC) and Fannie Maes, issued by the Federal National Mortgage Association (FNMA). They also require $25,000 and typically pay a higher rate than Ginnie Maes to compensate investors for the extra risk of not being government-insured.

The biggest disadvantages of all three mortgage-backed securities are an uncertain maturity and irregular monthly payments. Although the mortgages in their portfolios are issued for 30 years, the average life of a mortgage-backed security is only 10 to 12 years because homeowners frequently move or refinance. Also, if investors spend the part of their monthly check that is a return of principal, instead of reinvesting it, they will have nothing left when the last mortgage in their Ginnie Mae portfolio is repaid.

Collateralized Mortgage Obligations

Collateralized mortgage obligations (CMOs) are another type of mortgage-backed security. CMOs were developed to address investors’ concern about receiving income from other mortgage-backed securities in unpredictable increments. With CMOs, the portfolio of mortgages is divided into various classes, called tranches, thus offering investors a choice of estimated maturity dates to match financial goals. Investors in a particular tranche receive periodic income payments (typically monthly) that differ from period-to-period and from other tranches. Tranches with a longer maturity generally pay a higher return to compensate investors for incurring greater interest rate risk. The principal portion of mortgage payments corresponding to all tranches goes to investors in a single tranche until that tranche is retired. Each tranche gets its principal back when all the tranches before it have been repaid. CMOs are available in $1,000 increments through brokerage firms and pay a higher yield than comparable mortgage-backed securities. Two disadvantages are their complexity and the fact that principal prepayment can still come sooner (or later) than expected. Just as with other mortgage-backed securities, investors must realize that principal is being repaid throughout the life of a CMO, not at maturity like bonds. Investors who mistakenly think that CMO payments are just interest may inadvertently spend their principal.

Annuities

An annuity is a contract with an insurance company to provide regular income immediately or at some time in the future for a specified period (e.g., the lifetime of an annuitant or an annuitant and his/her spouse), typically during retirement years. In return, an investor deposits a sum of money with an insurance company, which grows tax-deferred until withdrawal, or makes periodic payments. There are two types of annuities: variable annuities which provide access to growth-oriented (ownership) and income-oriented (loanership) investments through a choice of mutual fund subaccounts, and fixed annuities that guarantee a fixed rate of return for a specified period of time. Thus, fixed annuities are like a CD, but are tax-deferred. A rate of return is locked in for a period of 1 to 5 years after purchase and then adjusted annually according to market conditions. Annuities generally require a $5,000 minimum investment. Annuity investors should compare surrender charges (a fee assessed for cashing out early), rates of return, and the financial health of insurance companies that offer annuities. Be sure to check with rating services such as A.M. Best, Moody’s, and Duff and Phelps and stick with top-rated insurance companies.

Preferred Stock

Although technically a form of stock, preferred stock is often listed as a fixed-income investment because it behaves more like a bond, but has no fixed maturity date. The word "preferred" refers to the fact that shareholders receive preferential treatment. They are paid dividends before common stock shareholders and, in the event of a corporate liquidation, can claim corporate assets after bondholders but before common stock shareholders. Preferred stock typically pays a fixed dividend rate similar to the coupon rate on a bond. Share prices fluctuate inversely with changes in interest rates. Par value on preferred stock is usually about $25 per share so a round lot (100 shares) would cost $2,500. Dividends paid are a fixed percentage of par value.  Preferred stock shares are available through brokerage firms.

Guaranteed Investment Contracts

Called GICs for short, guaranteed investment contracts are fixed-income contracts issued by insurance companies as an investment option for 401(k) retirement plans. Another, more commonly used, name for GICs is "stable value funds." Like CDs, only tax-deferred, GICs pay a fixed-interest rate for a specified period of time (e.g. 3 to 5 years). Because they are backed by an insurance company, and not the federal government, GICs generally pay a higher return than CDs and other cash investments. Their return is lower than stocks, however, leading to criticism that they are inappropriate for long-term financial goals like retirement.

Summary

Fixed-income investments involve loaning money for a period of time in exchange for periodic interest. Income is the primary objective and some investments also have growth potential if sold for a premium prior to maturity. This unit has reviewed characteristics of 15 specific fixed-income investment products, including advantages, disadvantages, and required minimum investments. Now you need to consider appropriate fixed-income investments that mesh with your personal financial goals. Complete the action steps listed below and use the Fixed-Income Investment Comparison Worksheet to make investment decisions.

Fixed-Income Investment Comparison Worksheet

  Action Steps: Fixed-Income Investing

References

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O’Neill, B. (1998, Oct.). Are Treasuries worth a second look? NAPFA Advisor, 36-42.

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Who needs a bond fund? (1997, Sept.). Consumer Reports, 41-44.

Zwieg, J. (1998, June). Don’t believe the bull: Bond funds do have a place. Money, 63-64.

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