Risks with Fixed Income Investments

The primary goal of fixed income investments is to see them provide a level of income, which usually means income that we will be using in our day to day financial management.

This is the difference between speaking of investments which are considered to be in the income class, bonds and preferred shares for instance, and a fixed income strategy of investing. Fixed income strategies do involve owning investments in the fixed income class, as well as utilizing the income features of the investments as income.

Risks with Fixed Income InvestmentsBonds and preferred shares pay income, as well as investments in the savings class such as a certificate of deposit and other income style savings investments. What distinguishes savings class investments from income class ones is that the value of the savings instruments are fixed as well as the amount of interest they produce, where with fixed income class investments, their interest is fixed but their value varies according to the market with them.

This is because fixed income investments are traded, where once you buy a certificate of deposit or similar investment, you own it and cannot sell it, and the most you can do, in certain cases, is to redeem it early, although this does result in a loss of interest.

We could say that the goals of investing to earn income is similar with both of these types of investments though, which is to generate income for ourselves. Investors often will either trade fixed income securities with a view of closing their positions later at a profit, selling it for higher than they paid or covering their positions at a lower price and achieving capital gains that way.

They may also be more focused on the interest that these investments bear over time, or may be looking to improve their yield by using a hybrid strategy of seeking both capital gains and interest income, as a means of increasing the overall value of their portfolios.

With fixed income investing though, once again, we’re looking to generate income at some point in time, usually in retirement, and while we may not be in retirement yet, we still can invest with a view toward this. Generally though, focusing more on fixed income results does occur in the later years of one’s career, because prior to that, looking to grow our portfolios usually is more of a priority.

The Biggest Risk With Fixed Income Strategies is Falling Short of Income Goals

When we place the majority of our portfolio in fixed income investments, with the intention of using the interest we earn as income, either now or at some later time, we can think of this as sacrificing at least some of the potential for growth in exchange for more predictable and reliable returns.

Growth class investments, stocks, generally will deliver about twice the return on average per year over what fixed income securities deliver, and this is the reason why fixed income strategies make more sense to pursue in the later years of our working career, and less so in the earlier years where we both have the time horizon to take more advantage of growth type investments and also are further away from needing to have them provide income for ourselves.

Ideally, we will be in a position where we will have grown the value of our portfolio overall to the point where we can move more if it to fixed income investments and have them provide us enough income to live out a comfortable retirement.

All the real risks that are involved with this strategy will depend on how successful we have been in growing our portfolio enough to provide us with a means of generating enough of this income later.

Even in the early years of one’s investing, we need a good plan, which will involve both managing returns and risk, to get us to the point where we can use the proceeds of our efforts to enhance our income at some point.

This may or may not be in retirement, but it generally is, we might have other goals prior to that though. If retirement savings is the goal, we may wish to continue investing in the stock market and either use dividends, capital gains, or even spend down our capital to provide the income we will need in our later years.

We may also look to do so by moving more into fixed income investments later, and given that, we need to look toward having enough to be able to have the amount of income we need or seek provided by this strategy.

If we do not accomplish this, this can lead to a failure of the strategy to various degrees, where we may end up spending down our principal, in an escalating fashion, and then be left to live out our final years with degrees of financial hardship.

So when we look at the various risks involved in a fixed income strategy, the risk of just not having enough invested at the time where we’re planning on having this income available to use is certainly a big one, and the one that we need to focus on first and foremost.

To look to mitigate this, looking to save more is an obvious way to look to deal with it, although we may also want to look at investing our money more aggressively if needed, while at the same time looking to manage the increased risks that are associated with this. While more aggressive investing can produce better returns, it also can produce larger losses as well, so we need to pay well attention to both potential returns and potential risks.

Market Risk with Fixed Income Strategies

While market risk, the risk that we may need to sell off our investments during a down turn in their prices, is less of a concern with income class investments such as bonds as it is with growth class investments such as stocks, this still may be a concern if we need to sell our investments in order to access the principal to supplement our income.

Ideally, when it comes to risk, we will have more than enough invested in fixed income investments to take care of us for the rest of our lives. Very often though we don’t have this luxury and may either have to draw down against the principal of our investments or at least be at risk of doing so depending on the circumstances.

These circumstances may include significant unforeseen expenses, or it may involve the yields of our investments not being able to keep up with inflation, or both. The risk with fixed income investments as far as their being exposed to market risk mostly has to do with interest rates increasing while we’re holding the investment, expressed as the difference between where interest rates were at the time of purchase and where they are presently at the time that it needs to be sold in the market.

The value of fixed income investments is inversely related to interest rates, where they become more valuable as interest rates decline, maintain their value when interest rates are stable, and lose value when interest rates rise.

This is because the relative value of a given stream of interest income will increase or decrease based upon comparing it to what the investment is paying now. If you buy a government bond that pays 2%, and later, you are looking to sell it when these bonds are now paying 4%, you will have to sell at a price that is low enough to make your 2% rate attractive in the market.

The only way this can happen is if you sell it at a lot lower price than its value at maturity, so that the buyer can make enough off of the capital gains to make up for the lower interest rate that it pays.

If you need to sell at a loss, and you are needing to sell because you need the money to live on, selling at a significant loss will exacerbate the problem. Therefore, fixed income investments aren’t just necessarily buy and forget about them, especially if you foresee the need or even possible need to liquidate them prior to maturity.

Inflation Risks With Fixed Income Strategies

Aside from interest rates going up, there’s also the risk of inflation reducing the value of your income flow. If you buy 30 year bonds with the expectation of living off the interest that it will pay, this might be plenty based upon today’s rate of inflation, but as inflation rises, the value of this interest will decline in purchasing power.

Since we almost always have inflation, unless we’re in a deep recession, we can count on these interest payments declining over time, and we need to prepare for it.

The true value of any investment is its returns net of inflation, and this is just as true with fixed income yields, and it’s even more important to pay attention to with these investments, since this directly affects our ability to manage our day to day expenses.

The best way to look to manage this particular risk is to not have too much invested in longer term investments, especially if we expect inflation to rise significantly. Longer term bonds pay more in interest though, so that has to be taken into account as well, but we need to make sure that we’re not putting too much of our money in long term bonds regardless, as this exposes us to more risk.

This is the reason why the longer term bonds pay more, as they do look to capture this additional risk, but depending on one’s circumstances, one may be more or less able to bear this risk. As a rule of thumb, the more one is able to tolerate inflation risk, meaning that one’s resources are sufficient to cover a certain amount of it, the more they are able to comfortably hold more long term securities, and vice versa.

It really does come down to a bigger portfolio being better though, with fixed income strategies or any other strategy that involves us living off the fruits of our investments one day, and if one is able to save more over time, that’s the cornerstone of managing any future risks that the strategy will not work out as well as expected or needed.

Aside from that, we need to be careful of not committing ourselves to a fixed income strategy too early on, so that we can grow our portfolio enough, not exposing our portfolio to too much risk while doing so, and when we’re executing our fixed income strategy, not exposing ourselves to excessive interest rate or inflation risk.

Fixed income can be a great tool to manage our investments in our later years, but the better our plan, and the better we execute it, the better the results will tend to be.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

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