Introduction
This post will present a general overview of fixed income investments. For some more specific examples, take a look at our previous post on the subject. A fixed income product is an investment that makes regular interest payments over a length of time. The interest payment amounts are typically determined at the time the investment is purchased, although there can be some variation in the amount and timing of the payments. Fixed income investments account for a huge percentage of the total investment market globally; the fixed income market is around two times larger than the global stock market. Fixed income investments are also typically much lower risk than stocks; however they also offer lower possible returns. The three most commonly encountered fixed income investments by the individual investor are bonds, GIC’s, and annuities.
Bonds
Bonds are financial instruments that pay interest at regular intervals for a certain amount of time. The interest amount is referred to as the bond’s coupon, and the length of time is referred to as the bond’s maturity. Once the bond reaches maturity, the investor receives back the initial purchasing price of the bond, also known as the face value, or principal of the investment.
Bonds can be purchased from governments or from corporations. There are many varieties of bond maturities, from less than a year to more than 10. Treasury Bills or T-Bills are a type of short term bond that behave differently from conventional bonds. Instead of paying regular interest, they are sold at a discount compared to the face value. The difference between the selling price and the face value provides the return.
Bonds can also be bought and sold on the open market at any time before maturity. On the open market, the price of a bond depends on supply and demand, behaving much like other market based investments. Generally, the market price of a bond varies inversely to the current interest rate; as interest rates rise, existing bonds will go down in value. This occurs because when the interest rate rises, new bonds will provide higher returns. As a result, fewer people will want to purchase the older and lower interest bonds, so the price drops in order to make their interest payments more appealing for purchase, and vice versa.
There is also an important distinction between individual bonds and a mutual fund that invests in bonds. With an individual bond, the face value is protected if you hold the bond to maturity. This is not the case for a bond mutual fund because you must sell your shares in order to redeem your cash. Like all mutual funds, the share price is subject to market pressure and can go down resulting in a net loss of principal.
GIC
A Guaranteed Investment Certificate (GIC) is an investment that guarantees the initial principal and earns interest. GIC’s are purchased for fixed periods of time, after which the GIC matures. In this way, GIC’s are very similar to a conventional bond, however, the major difference between the two investments is that with a GIC you are typically restricted in your ability to sell the investment prior to maturity, vs. with a bond, you can sell on the open market for some recovery (or potentially a profit) of principal.
Another important difference is that GIC’s are covered by the Canada Deposit Insurance Corporation (CDIC). This protects the money invested in a GIC, up to $100,000, in case of a bank failure. Bonds, on the other hand, do not enjoy this type of coverage. For more details on what the CDIC covers, follow this link.
Annuity
An annuity is a sum of money that is regularly paid out over a set period of time. Typically an annuity is purchased with a lump sum, which is then returned to the buyer in regular installments. The annuity typically earns interest while being paid out. Depending on the annuity product, the interest may be guaranteed, variable, or linked to a market index.
Some annuity products are for life and will make payments until the buyer passes. These products are sold by insurance companies, who assume the risk that the purchaser will live longer than the average life expectancy. If the buyer dies early, the insurance company keeps the money that hasn’t been paid out. As mentioned, other annuity products specify that their payments end at a fixed date, so there is a risk of the purchaser outliving the annuity. However, in both cases, if the original purchaser passes before the annuity term is up, the payments can often be directed to a beneficiary. For further details, have a look at this post.
Conclusion
Fixed income investments are, along with equity investments, an essential component of an investor’s portfolio. They generally offer lower risk, but also lower return as compared to equities. However, as an investor gets older and their risk requirement (and tolerance) decreases, protection of principal becomes more important. This means investing in more fixed income investments as you near retirement.
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