Is fixed income investment risk-free?

Fixed income investment is often the first choice for many who want to invest conservatively. With a stable and predictable income, investors can just sit back and let their money earn passively. While safer than many other investments out there, fixed income investments are not immune to risks.

Here we will look at the following regarding fixed-income investments:

1. What is a fixed income investment?

Fixed-income investment is where investors are paid a fixed interest until its maturity date. After maturity, investors receive the principal amount they invested. Fixed income investments are often debt instruments, where the borrowers issue them to finance their operations, and investors buy the instruments to receive a monthly fixed income. The interest amount does not rely on the profit or loss of the operation, unlike equities - where the income is variable and dependent on surplus/loss. Investors of fixed income instruments are often the first creditors in line to be paid when the borrowers face insolvency.  

Fixed-income investment is not only for conservative investors but also for people who want to diversify their portfolios. Portfolio diversification between fixed income and equities balances the return with risks. 

Some of the most common examples of fixed-income investments are:

  • Bonds - consisting of government bonds, corporate bonds, junk or high yield bonds, and municipal bonds
  • Fixed-income mutual funds or bond funds - an active investment fund where the fixed income portfolio is managed by a professional
  • Certificates of deposit - protected by the guarantee fund, CDs require the money to be in the account for some time (usually less than 5 years). Interest rates are higher than the usual savings account due to restricted liquidity
  • Fixed-income exchange-traded funds (ETF) - similar to actively managed mutual funds where it tracks the performance of a bond market index

2. Why should you invest in fixed income tools?

Fixed income investing perfect for individuals who may not have a high-risk tolerance. With their stable and regular income stream, investors have more opportunities to diversify their portfolio to offset the more volatile investment, such as stocks. 

Moreover, investors’ rights and funds are backed by the issuer and, often, the state. Bonds are popular because the risks are not as high as stocks or other equities, and investors enjoy a contractual assurance. And even if the bond market suffers from fluctuation, the investor is bound to receive the money-back under contractual obligation. In terms of corporate and junk bonds, bondholders will be the priority creditors in case of liquidation. In the case of government and municipal bonds, their money is protected by state regulations. In CDs, the account holder carries mandatory protection up to 100,000 EUR by the guarantee fund. 

Fixed income mutual funds and ETFs have the same benefits as normal mutual funds and ETFs. Aside from providing fixed interests, they are both liquid, and the cost of investing is lower than securities. 

Does that mean that fixed-income investing is risk-free? Not at all - the risks under fixed income varies from other investment, and they are more subtle and reliant on external factors.

3. The risks of fixed income investments

Risks of fixed income investment depend on the instrument. The risks of bonds are different from CDs and mutual funds. The following analyses the different kinds of risks of fixed income investment:

  • Interest Rate Risk: For bonds, in general, it suffers from interest rate risks. If the interest rate rises, the prices decline, and if the prices increase, then interest rates will fall. In these events, investors can sell off a bond in the secondary market rather than hold it until maturity. Depending on the price and interest rate, the investor may profit or suffer losses 
  • Credit risk: Bonds also carry a risk of default (credit risk), especially for junk bonds and corporate bonds. The borrower may be unable to pay back the investor the principal money or the interest. CDs usually do not carry credit risk if the money in the account is below the guaranteed amount. Any money above the guaranteed amount is subject to credit risk if the bank goes bankrupt
  • Inflation risk: Inflation is a concern for many who plan to live off their savings investments. And it should be because rising inflation impacts the purchasing power, and the things that were once affordable no longer is. Savings account. CDs and bonds are particularly prone to inflation risk since the income is disproportional to the value lost to inflation

4. Hedging against the risks of fixed income investments

There is no way to eliminate risk on fixed income investment completely. However, you can hedge against those risks. Optimal asset allocation and portfolio diversification are critical for hedging investment risks in general. For individual types of risk, it depends on the type of investment instrument because each instrument has its own volatility and risks, and some require specific preventive methods to minimise losses against returns: 

  • Interest rate risk: You can hedge the interest rate risks of fixed-income investment with other fixed-income investing tools that rely on futures, such as forward contracts. In forward contracts, you can short sell your investment in the future at a fixed price. This will allow you to recover losses from the interest rate
  • Credit risks: You can mitigate credit risks by charging higher interest rates to borrowers with lower credit ratings. You can also buy credit insurance to transfer the risks of the investment to the insurer. Lastly, you can hold collaterals as pledges from the borrower, which you can liquidate to compensate for your losses
  • Inflation risks: You can hedge against inflation risk by diversifying your portfolio with assets that yield higher returns, such as equities. It will offset both risks from equities and your fixed-income investment 

Fixed income investing perform best when combined with other investment strategies that aim for higher returns. Fixed income investing is designed to mitigate the risks associated with high-risk equities, such as stocks, and to balance equities' volatility by providing a cushion to limit your losses.

Last update: 10/08/2021

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