Governments issue bonds to raise money for public projects such as roads or building new schools.
Fixed income instruments are securities in which an investor receives regular income payments over a period of time. Typically, fixed income instruments take the form of debt securities such as bonds, although some dividend-paying stocks also pay a fixed income. Retirees often use income instruments to generate supplemental monthly income.
Bonds are a form of debt where a creditor lends money to the debt issuer and charges the debt issuer monthly or annual interest. Governments issue bonds to raise money for public projects such as roads or building new schools, while companies issue bonds to raise the revenue needed for mergers and acquisitions. Bond terms typically last at least six months, although national governments issue bonds lasting up to 30 years. Long-term bonds pay lower interest rates but appeal to people looking for predictable payments over long periods of time. In the United States, municipal bond income payments are not taxable at the federal level, which makes them especially attractive to investors in high tax brackets.
Common shares are not considered fixed income instruments because the value of the shares fluctuates daily and dividend payments are subject to change. Many large companies issue preferred stock, which pays fixed dividends. Preferred stock dividends are normally taxable. To make stocks an attractive investment, dividend payments on preferred stocks are generally higher than yields paid on bonds.
Investors purchasing fixed income instruments are exposed to a variety of different risks, including insolvency risk, as an issuer of government or corporate bonds can only continue to make regular income payments as long as it remains solvent. If a bond issuing entity files for bankruptcy, bond payments generally cease. Many bondholders eventually get a portion of their investment back, but the loss of income can be problematic. When a company goes bankrupt, preferred shareholders can claim a portion of the bankrupt company’s assets, but only after taxes, payroll, and debts have been settled. Preferred stock often loses value after a company becomes insolvent, and many investors lose both a source of income and their original investment.
People who rely heavily on fixed income instruments also have to face the risk of inflation. Prices tend to increase over time, which causes the cost of living to rise steadily for long periods of time. Fixed income payments remain unchanged, which means that inflation erodes investors’ purchasing power. Some investors prefer to buy investments that offer variable rates, such as variable rate certificates of deposit, but while these investments do not expose people to the risk of inflation, investors cannot anticipate paying income from one month to the next.