Fixed-income investments, such as government and corporate bonds, can provide a steady, predictable source of income, often with lower risk than other investments. Along with stocks and stock mutual funds, fixed-income investments make up the backbone of a well-diversified investment portfolio.
What is fixed-income investing?
Unlike many types of investments, fixed-income investments don’t need to be sold to generate a profit. To illustrate how this works, let’s look at one of the most common types of fixed-income investments: bonds.
Bonds are really just a loan from you to a corporation or government that pays interest over time, plus the principal amount at the end of a predetermined period. For example, if you buy a 10-year bond with a face value of $5,000 that pays 3% interest, you’ll earn $150 per year for 10 years. This interest can be paid out at different intervals, such as monthly, quarterly or semi-annually. After 10 years, you’ll have earned $1,500 in interest, and the government or corporation will also pay back the principal amount of $5,000.
The periodic interest payments of fixed-income investments are yours to use however you want. These payments will, however, be taxed as income, though there are many nuances to this, as outlined below.
One important note: Just like stocks, bonds can be bought and sold on the secondary market — which most investors today access through an online brokerage — giving them a value that could be more or less than they initially cost. Selling a fixed-income investment for a profit on the market is an option, though it’s often the regular payments investors are after, not the capital gains.
Fixed-income investments expand beyond just bonds, though. Instruments such as preferred stocks or even bank certificates of deposits can also be included in this category. But for many investors, bonds will make up the majority of their fixed-income holdings.
Why include fixed-income investments in a portfolio?
Aside from a steady source of income, fixed-income investments are a staple in any investment portfolio for a few reasons.
One of the primary reasons is diversification. The goal of diversification is to lower the volatility of your portfolio’s performance by spreading the risk. This can be accomplished through stocks alone — investing in various companies from different sectors is a form of diversification — but fixed-income investments provide even more stability for one main reason: Bond values often behave inversely to stock values.
The value of bonds typically rises and falls opposite to stocks, in part because investors tend to see bonds as a safer place to put funds during volatile periods (more on this below). So, if the stock portion of your portfolio is down 10% but the bond portion is up 4% (and your portfolio is 50% bonds and 50% stocks), your overall losses are only 6%.
Brett Koeppel, a certified financial planner in Buffalo, New York, and founder of Eudaimonia Wealth, says investors can think of fixed-income investments as “shock absorbers” against market downturns.
“During stock market volatility, fixed income typically maintains or even increases in value,” Koeppel says. “By spreading your holdings across different asset classes, you’ll be in a better position for rebalancing opportunities in order to make sure your money is properly aligned to life and what you’re hoping to achieve by investing.”
So how do you know the right allocation between stocks and bonds? According to Koeppel, there are two main things to consider when assigning your portfolio’s allocation: where the fixed income fits into your overall financial picture and when you expect to actually use it.
In general, advisors typically recommend allocating toward fixed-income investments as retirement approaches. In doing so, you’ll reduce the risk of market-based turmoil taking an oversized bite from your portfolio at a bad time.
Bonds are often less risky than stocks, but they do have a few risks that are worth considering.
When buying bonds, consider the creditworthiness of the issuer. That is to say, how likely is it that the government or company will repay its debt to you? If the issuer declares bankruptcy, the interest payments will stop, and it’s possible you won’t get back your entire principal. You can learn about an issuer’s creditworthiness by checking its credit quality ratings through firms like Moody’s Analytics and Standard & Poor’s.
For reference, investment-grade bonds are those that are the least likely to default and have a credit rating of BBB or above (Standard and Poor’s) or Baa and above (Moody’s). Conversely, bonds below this threshold fall into the high-yield bond — otherwise known as junk bond — territory.
While this isn’t much of a risk for U.S. government bonds, the risk of default should definitely be a consideration when buying corporate bonds, says Koeppel.
“With corporate bonds, there is a trade-off between the amount of interest you receive from a bond and the perceived creditworthiness of the issuer, or the likelihood that the company repays your full investment,” Koeppel says. “High-yield bonds pay you more in interest than investment-grade bonds because there is a greater possibility that the issuer could default on its debt obligation. If that happens, you may not receive the full value of what you originally invested.”
Much of a bond’s value comes from its periodic interest payments, which are fixed. If overall interest rates rise, however, then newly issued bonds — and their higher interest payment — will become more attractive, lowering the market value of the older bonds with lower interest rates.
Conversely, when interest rates fall, newly issued bonds will offer lower interest payments, making the older bonds — whose payments are now higher than the new bonds — more attractive.
Bonds may be less risky than stocks, but they often don’t offer investors the same level of returns. Typically, investors allocate more of their portfolio toward stocks early on, then gradually shift it to bonds as they near retirement. This strategy maximizes long-term growth while minimizing risk as retirement approaches. Even with diligent saving, an all-bond portfolio may not grow enough to be sufficient for retirement.
Types of fixed-income investments
There is a wide range of fixed-income investments, but the most common are outlined below.
Treasury securities are the federal version of municipal bonds, and since 2012, they have made up the largest portion of the U.S. fixed-income market, accounting for about 37% of its total value in 2019.
These investments are issued and backed by the U.S. government, and come in three forms: notes, bills and bonds. The biggest difference between these three is how long it takes for each one to reach maturity, noted below:
Bills. Up to one year.
Notes: 2, 3, 5, 7 or 10 years.
Bonds: 20 or 30 years.
The risk of the U.S. government defaulting on its bonds is virtually nonexistent, which secures bonds’ status as a safe long-term investment with consistent returns.
Municipal bonds are similar to Treasury bonds but are issued by state and local governments. They operate in virtually the same way but often come with an additional benefit: federal tax exemption.
Generally, the interest generated by municipal bonds is free from both federal and state taxes (although this can vary by state). However, they typically provide lower yields than other forms of bonds. These are often recommended for investors already in high tax brackets.
Municipal bonds are generally low risk, as municipalities can introduce new taxes to pay back bondholders. Between 1970 and 2016, the five-year municipal bond default rate was just 0.07%.
If municipal and treasury bonds are the lowest-risk, lowest-return options among common fixed-income investments, corporate bonds are the next step up in terms of the risk/reward relationship. These investments account for about 21% of the U.S. fixed income market.
Corporate bonds act similarly to Treasury securities, only you’re giving a loan to a corporation, not the government. The more stable and established the company, generally the safer your investment will be. This is where the aforementioned credit ratings come into play. Highly rated companies are the least likely to default on their debt, making their bonds strong candidates for reliable fixed-income vehicles.
Moving up the risk/return ladder, you’ll find high-yield bonds, otherwise known as junk bonds. These fixed-income securities fall below the investment-grade threshold assigned by credit rating agencies, but as their name suggests, they tend to offer higher interest payments in return for taking on more risk.
Despite their unflattering nickname, high-yield bonds still made up 5% of the total fixed-income market as of Dec. 31, 2018.
All the fixed-income investments discussed above can be found in the form of mutual funds and ETFs. These products bundle several types of bonds into a single basket, adding even more diversification to your portfolio through a single investment.
Taxes on fixed-income investments vary, though these differences are relatively straightforward. The table below is broken up by the type of security, the state and federal taxes on interest payments and the capital gains taxes you’d incur if you sell the bond before maturity.
Federal income (interest payments)
State income (interest payments)
Capital gains (sell before maturity)
Varies by state
How to invest in fixed-income securities
Ready to start generating fixed income? Here’s how.
New-issue Treasury securities. The easiest way to buy newly issued U.S Treasury securities is through treasurydirect.gov.
Municipal bonds. There are a few ways to buy municipal bonds, but the easiest would be through a brokerage account. Most major online brokerages will have municipal bonds on offer.
Corporate and high-yield bonds. You’ll need a brokerage account to purchase these. Once you’ve set up your account, you can use the brokerage’s screening tools to find the bonds that best fit your situation and portfolio.
Secondary market. You’ll need a brokerage account to buy or sell all bonds on the secondary market.