Fixed income funds, including mutual funds, can play an important role in your portfolio by providing current income as well as adding diversification.
Ok, so let’s state why fixed income funds and fixed income in general is worth talking about:
“When the periodic income generated from your fixed income investments meets or exceeds your periodic expenses, you are free to enjoy life and spend your time on things you choose versus something you don’t like. Your goal is to create a fixed income portfolio that does just that while taking on the least amount of risk.” Mike O.
If you are going to seriously prepare for a lasting and quality retirement, it is important that you learn about fixed income. Once you understand the basics, you will understand what to look for when selecting fixed income funds. I will write more about the different ways to research and analyze fixed income funds in another post. We are just sticking to concepts today. Like anything, once you learn the concepts, you will be able to do your research. Ok, so lets talk about some basic terms.
Fixed Income Bond Basics
A bond is an IOU, issued by a company, government or government agency/municipality. You are essentially lending your money to the bond issuer for a specified time period (term). This is why it is crucial to thoroughly understand the health of the issuer.
In agreement for your money, the issuer agrees to:
- Repay the face value of the bond on the maturity date, which is when the principal amount of the bond becomes due and is payable.
- Make periodic interest payments which creates a fixed income stream for you. This is why most people living on fixed income prefer bonds. They offer consistent fixed income payments. The goal is for your monthly fixed income payments to exceed your monthly expenses!
Usually, the interest rate paid by a bond cannot change, which is why bonds are referred to as fixed income. Lets talk about how bonds/fixed income investments can benefit you the investor. Bonds can help you make money in two ways:
- Bonds pay interest. As you get closer to retirement, the appeal of regular, fixed-interest payments until the bond matures, is attractive to retirees.
- Capital appreciation. Prior to maturity, the value of any bond may rise or fall depending on market conditions. You can realize a capital gain or a loss by selling a bond before maturity.
Term or Maturity
A bond’s maturity indicates when its issuer is required to repay the principal back to you the bond holder – Here are the different terms of bonds and fixed income fund categories:
- Ultra Short-term—typically less than 2 years
- Short-term—typically less than 3 years
- Intermediate-term—between 3 and 10 years
- Long-term—greater than 10 years and usually up to 30 years
The term or maturity of a bond affects its price stability. A longer-term bond or fixed income fund offers a higher interest rate to compensate you for the risk of tying up your principal for a longer period of time at a fixed-interest rate.
Bond prices and interest rates
Bond prices can fluctuate in response to credit quality, market supply and demand, and shifts in interest rates. Interest rate changes usually have the most impact on bond prices. Generally, the longer a bond’s maturity, the higher the interest-rate risk, or the more sensitive its price will be to interest rate changes.
Note: Bonds or fixed income funds with less than 2 or 3 year maturity usually does not carry interest rate risk. This means when rates change the price of the bond will remain mostly stable.
These are just basic concepts. As I mentioned earlier in this post, fixed income will mostly likley become a central theme in your retirement planning goals. Take a little bit of time to understand these concepts now and you will be glad later.
Remember the concept of fixed income as a tool is this:
- When the periodic income generated from your fixed income investments meets or exceeds your periodic expenses, you are free to enjoy life and spend your time on things you like versus things you don’t like.
THIS is at the core of creating financial independence.