Why invest in fixed income?

Why Invest in Fixed Income?

We believe fixed income plays an essential role in an investor’s portfolio. Learn about the potential benefits of fixed income investments and whether they are right for you.

Introduction to bond investing

Introduction to bond investing

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- We often get questions from investors about owning bonds.

Collin, can you give us some insights about bond investing?

- We see three key reasons why people should own bonds regardless of the interest rate environment and regardless of the economic environment.

Those reasons are income, relative price stability and capital preservation, and the diversification benefits they provide.

The first benefit is income.

Bonds are contractually obligated to make interest payments, so barring default, you generally have a good idea of how much income you'll
be receiving and when.

The second benefit is relative price stability and capital preservation.

Bonds have set maturity dates and set par values, so you can generally have a good idea--

once again, barring default-- of how much you're going to receive at its maturity date.

Now, bond prices can fluctuate in the secondary market, but for high-quality bonds with short- to intermediate-term maturities, the price volatility is significantly less than those seen in the stock markets.

And the third benefit is diversification. For a well-balanced portfolio, it's best to have investments that aren't all moving in the same direction.

Over time, the prices and returns of high-quality bonds, like U.S. Treasuries, aren't very correlated with stocks.

So during periods of stock market volatility or stock market declines, holding high-quality bonds can help serve as a
ballast for your portfolio and could limit the overall decline if we did experience some stock market volatility or price declines.

- Those are three great reasons to own bonds. Can you tell us about the risks?

- Bonds generally have two key risks, interest rate risk and credit risk.

Interest rate risk is the risk that a bond's price will fall if its yield rises because bond prices and yields generally move in opposite directions.

But not all bond prices will fall by the same amount. A major determinant in price sensitivity to a change in yield is time to maturity.

Short-term bonds tend to be less sensitive to changing interest rates than long-term bonds.

Now, the second key risk is credit risk, or the risk that an issuer can't make timely interest or principal payments or generally leads to a default.

Now, some bonds, like U.S. Treasuries, have very low credit risk, but other bonds, like high-yield corporate bonds or emerging market bonds, have heightened credit risk and therefore amounts to more price volatility.

Now these types of bonds generally have lower credit ratings and have the potential to suffer price declines.

- Thanks for talking to us about the risks as well as the benefits in owning bonds.

You can find more information about investing in individual bonds, ETFs, and mutual funds, as well as separately managed accounts, on Schwab.com.

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Think about your objectives.

Whether your goal is to diversify your investments, save for the future, receive dependable income, preserve principal, or minimize taxes, fixed income investments could be a way to reach your goals.

Benefits to investors:

  • Adding bonds to a stock portfolio may help to smooth out the highs and lows.
  • Bonds are designed to preserve capital and are therefore great for saving for a future expense.
  • Many bonds have preferential tax treatment where coupon payments are exempt from federal and potentially state income taxes.

Let’s start with the basics of fixed income.

Fixed income investments get their name because they're usually designed to generate a specific, or "fixed," level of interest income. Common fixed income investments include Treasury bonds, government and agency bonds, municipal bonds, corporate bonds, and mortgage-backed securities, as well as certificates of deposit and preferred stock or securities.

Understand the different types of securities.

  • Individual bonds

    Bonds typically pay a set schedule of fixed interest payments and promise to return your money on a specific maturity date. They are issued by a variety of entities, such as the U.S. Treasury, government agencies, corporations, and municipalities.

    Schwab gives you access to over 60,000 bonds from more than 200 dealers.1

  • Bond funds and exchange-traded funds (ETFs)

    Bond mutual funds and bond ETFs are professionally managed investment products made up of a diversified mix of underlying securities. Many have low investment minimums.

    Through Schwab, you can access no-load, no-transaction-fee bond funds through Mutual Fund OneSource® and bond ETFs that trade commission-free online.2

  • Certificates of deposit (CDs)

    CDs are bank deposits that pay a stated amount of interest for a specified period of time and promise to return your money on a specific date. CDs are insured by the FDIC, which provides an added level of safety.

    You can find and manage high-yield CDs through Schwab CD OneSource®.

  • Preferred stocks/securities

    Preferred stocks/securities are a class of stock that must pay dividends or interest to preferred shareholders before dividends are paid to common stockholders. They are issued by corporations and have attributes that are characteristic of both stocks and bonds.

    Schwab gives you access to new-issue and secondary market preferred stocks/securities.

  • Managed accounts

    A managed account is a portfolio of individual securities that you own. The securities are chosen and managed on a discretionary basis by an asset management firm.

    Each professionally managed account follows a focused strategy within a specific asset class or investment style.

Take a closer look at the benefits.

There are four key features to fixed income securities that make them desirable to investors: diversification, capital preservation, income generation, and potentially favorable tax treatment. Each feature provides a unique set of benefits that vary depending upon the type of fixed income security.

  • Diversification

    Fixed income securities, specifically high-credit-quality bonds, can help smooth out the highs and lows in a stock portfolio. That’s because stock and bond prices have historically tended to move independently and with different magnitudes at any given time. However, diversifying with bonds does not ensure a profit and does not protect against a loss in a declining market.

  • Capital preservation

    Fixed income securities are ideal when preservation of capital is a priority. Specifically with bonds, principal is usually returned at a set maturity date. Higher-quality fixed income investments, like Treasuries and CDs, have the best potential for protecting principal. Though preserving capital is a key feature of fixed income securities, there is still the risk that the issuer of the bond will not make good on paying back the principal.

  • Income generation

    Fixed income securities are typically designed to provide a regular, predictable stream of interest payments on set dates. Keep in mind that there is a risk that the issuer will not make good on the promise to pay interest income.

    There are three common choices for generating income:

    Individual bonds

    Pros:

    • Offer you control over what type of income you can expect to receive, and when
    • Have payment dates that can be staggered to help create more regular monthly income
    • Can be “laddered” to help manage liquidity and interest rate risk

    Cons:

    • Require more involvement to research, choose, diversify, and monitor

    Bond mutual funds and bond ETFs

    Pros:

    • Are great for diversifying holdings

    Cons:

    • Have income distributions that can fluctuate
    • Generally have no stated maturity date, so shares must be sold to get back the principal
    • Can have a potential loss of principal if they're worth less than they were when you bought them
  • Tax exemptions

    Some fixed income securities have preferential tax treatment where coupon payments may be exempt from federal and state income taxes.

    Keep in mind that potential tax advantages are generally factored into the price of any bond (and therefore its yield). Also, tax-exempt bond income may be subject to the alternative minimum tax (AMT), and capital gains are subject to federal and sometimes state and local taxes. Schwab recommends consulting a qualified tax advisor for specific individualized tax advice.

    Tax treatment is not the same for all types of bonds:

    1. Municipal bonds may have the greatest potential tax benefit because their interest payments are usually exempt from federal income and are potentially exempt from state income taxes for investors buying bonds issued in their home state.
    2. Treasury securities and some federal agency bonds pay interest that is generally exempt from state income taxes.
    3. Bond funds and bond ETFs that invest in securities whose interest is exempt from income taxes, like municipal bonds and Treasuries, generally pay interest that is exempt from income taxes, just like the individual bonds they own.

Avoid the three common errors that investors make.

Keep your bond strategy on course by understanding how to avoid the most common investing errors:

  • Chasing yield 
  • Buying and forgetting
  • Failing to diversify

Talk to a specialist

Get personalized assistance from a Schwab Fixed Income Specialist with your fixed income investing questions and pricing.

Call 877-906-4670.

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