Retirement Funds — Fixed Income Investments
Fixed income investments usually have the following features:
- Little or no fluctuation in principal
- A maturity date when the principal or face value is repaid
- Some guarantee or backing
- Fixed interest rate for a term
Retirement funds can be either allocated for growth or for retirement income.
Unlike equity investments which provide ownership, fixed-income investments,
on the other hand, are "loanership" assets; investors loan their
money to a government entity (e.g., state), corporation, or financial institution
(e.g., bank, credit union) and receive interest on a regular basis (e.g., monthly,
semi-annually). The rate of interest paid can either be fixed for the life
of an investment (e.g., Treasury securities) or can fluctuate with the general
movement of interest rates (e.g., series EE savings bonds). The principal (amount
of original investment) is returned at maturity (the date on which principal
must be repaid), although its value can fluctuate (if sold beforehand) according
to changes in interest rates. For many fixed-income securities (e.g., bonds),
as interest rates rise, asset prices decline and, as interest rates decline,
asset prices rise. This inverse relationship of interest rates and asset value,
called interest rate risk, affects the value of fixed-income securities if
you have to sell them prior to maturity. In other words, you could lose principal
if interest rates rise and you have to sell early.
Why Buy Fixed-Income Investments with your Retirement Funds?
There are many reasons to consider fixed-income investments for retirement
funds. One is that they add diversification to an investor’s portfolio.
Research by several Nobel prize-winning economists found that, for every level
of investment risk, there is a "best combination"
of assets that produces the highest rate of return. Investing in just one asset
class (e.g., stock, bonds, or cash), however, is less desirable than selecting
a combination of assets because doing so increases investment risk. It’s
like the old saying "don’t put all of your eggs in one basket." By
combining investments that are affected differently by economic events, investment
risk is reduced. While both stocks and bonds often are similarly affected by
interest rates in the short run today, over the long term they have had a relatively
low relationship to each other. The technical word for this is correlation,
which is a statistical term that indicates the degree to which the movement
of one variable (in this case, an asset class price) is related to another.
Besides diversification, there are several other reasons to consider fixed-income
securities for funding retirement income. First, they are a good option for
conservative investors who are fearful of ownership assets. If the price fluctuations
of the stock market are likely to cause sleepless nights, fixed-income investments
like bonds are less risky because investors are less likely to lose principal.
Most fixed-income securities also provide a predictable stream of income--a fixed retirement income. This
can be an advantage for current or near retirees who seek regular income to
supplement a pension and/or Social Security.
Predictability of investment return is a third feature of fixed-income securities.
The rate of return is fixed for the life of most investments and a certain
amount of retirement income can be counted upon (e.g., a 6% interest rate on a $1,000
corporate bond will pay $30 semi-annually). Some fixed-income investments also
provide tax advantages. Fixed annuities, for example, are tax-deferred and
municipal bond interest is federally tax-exempt. Some investments (e.g., bond
funds) also allow investors to reinvest earnings, plus most fixed-income securities
typically earn a higher return than bank accounts. This is especially true
for substandard grade bonds rated less than Baa by Moody's or BBB by Standard & Poor's.
Investment yields generally increase as the credit quality of a bond issuer
drops. Thus, investors can increase their income by purchasing lower-rated
bonds. Further information about bond ratings is available in many public libraries.
Fixed-income securities with longer maturities (e.g., 30-year bonds) typically
pay a higher interest rate than shorter-term investments (e.g., 10-year bonds)
to compensate investors for having their money "tied up" for additional
years and for increased exposure to price fluctuations caused by interest rate
risk.
Some fixed-income securities also have capital gain (or loss) potential. Capital
gains can accrue if investments are sold in secondary markets at a premium
(more than their face value) prior to maturity. Gains occur when interest rates
decrease and bond prices rise. A final feature of fixed-income investments
is affordability. Most investment products in this category require a minimum
purchase of $1,000 or less. Treasury bills and notes, for example, all require
minimum initial deposits of $1,000, as do corporate bonds, unit investment
trusts (UITs), and many bond mutual funds. Even among municipal bonds, which
generally require $5,000, some issuers offer $100 or $500 "minibonds" that
provide tax-exempt retirement income to small investors. Ginnie Maes, which require $25,000
to purchase directly, can be bought in $1,000 units through Unit Investment
Trusts (UITs). Series EE bonds can be purchased for as little as $25 and I
bonds for $50.
Five Tips For Fixed-Income Investors
1. Know the risks. All investments have risks, including fixed-income securities.
To earn a higher return, for example, an investor may need to consider bonds
from a less creditworthy issuer.
2. Beware of guarantees. Even with a portfolio of Treasury securities, an
investor can lose money via interest rate risk. Beware of promises that "you
can never lose principal." You can.
3. Ladder your retirement funds. Stagger the purchase of bonds, CDs, and Treasury
securities to spread out the tax owed and expose only a portion of your portfolio
to interest rate changes at any one time.
4. Use bonds to hedge stock investments. Have your cake and eat it too. Buy
a zero-coupon bond to guarantee the return of principal and use the balance
of principal to invest in ownership assets (e.g., stock).
5. Match investments with financial goals. Invest with a goal in mind. For
example, use a two-year Treasury note for an upcoming car purchase or an eight-year
zero-coupon bond for a child’s education.
Additional Resources
Dear Susan
MSN
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