Fixed income bonds are debt securities that have a fixed annual return based on a set interest rate. Governments and corporations issue bonds to borrow money, and they are legally obligated to pay back the loans plus the predetermined amount of interest to the lenders. The interest is paid out periodically, and the principal of the loans is paid back on the maturity date. Fixed income bonds are ideal for investors who want a predictable amount of income to supplement or substitute their earnings. Since these bonds are considered to be low risk, they will generally yield lower returns than variable securities.
The maturity dates and interest rates for fixed income bonds are determined at the time of issuance. The maturity period will usually be from one to ten years, and the interest rate remains the same throughout the chosen time frame. For example, a person might invest in a $1,000 US Dollar (USD) fixed income bond with a 6% interest rate and a 10-year maturity period. The bond will yield $60 USD on an annual basis, and the $1,000 USD principal will be paid to the investor on the maturity date in the tenth year.
Fixed income bonds offer several benefits to investors. They are considered to be low risk, which is attractive to investors who prefer safe investments that are likely to preserve the invested capital. The amount of income received from the bonds is predictable, and the investor is always aware of the final yield since the interest rate is fixed.
There are also many risks associated with investing in fixed income bonds. One risk is that the borrower might default on the payments, which is known as credit risk. The credit risk can be minimized by assessing the credit worthiness of the bond issuer before purchasing the bonds. There are rating services that evaluate the financial health of bond issuers and award the bonds a rating based on a particular scale. The rating that a bond receives helps investors to compare the credit quality of one bond to another.
Another risk is the inflation risk, which means that the annual inflation rates weaken the actual value of the return on the investment. One way to reduce inflation risk would be to invest in securities that are inflation protected, such as United States Treasury Inflation Protected Bonds. Inflation protected bonds adjust the final payout according to the consumer price index.
Additionally, if bondholders decide to sell fixed income bonds prior to the maturity date, then they could be impacted by changes in the market interest rates. If the market interest rates increase, then bond prices go down, and vice versa. The inverse relationship between interest rates and bond prices could negatively affect bondholders who wish to sell their fixed income bonds. Bonds with lower fixed interest rates than the current market interest rates would be unappealing to potential buyers.