Fixed Income Securities and Risks
Fixed income, or credit securities, are typically loans made between investors, corporations and government institutions. In exchange, investors receive fixed interest payments until loan principal is repaid at maturity. Bonds are the primary examples of fixed income investments. Although, fixed income securities generally attract conservative investors, these investments do carry distinct risks. Risk levels vary according to the type of fixed income investment purchased, alongside the prevailing economic cycle.
Credit risks identify the chances that an institution will default upon its debt, and fail to make full principal and interest payments. Credit rating agencies, such as Standard and Poor’s and Moody’s, rate institutions according to their ability to make payments. Investors demand higher interest payments to purchase fixed income that is associated with riskier projects. For example, high-yield, or junk, bonds identify distressed corporations that are in jeopardy of declaring bankruptcy. These companies must pay out high interest rates to sell their bonds and access credit financing. Credit risks do increase amidst economic recession. At that point, businesses struggle to generate adequate cash flow to make interest payments.
U.S. Treasuries, however, are not susceptible to credit risks. The Federal government carries the power to tax and create money—in order to always make payments on its debt. Because of this safety, treasuries generally pay the lowest interest rates—in comparison to comparable fixed income. Expect one-year treasury bills to pay less interest than certificates of deposit and bonds that also mature in one year.
Interest Rate Risks
Interest rate risks describe lost value arising from rising interest rates. When interest rates rise, new bonds pay higher interest than fixed income that is already circulating. At that point, old bonds must be sold at a discount to make up for the difference in interest rate payments from newer fixed income. Rising interest rates may signal that the economy is improving, which strengthens loan demand. High demand for loans supports higher interest rates.
Inflation refers to rising price levels that cut your purchasing power over time. Bonds that pay minimal interest rates are subject to long-term inflation risks. Interest payments may not keep pace with future inflation rates. Further, the Federal Reserve Board coordinates policy to raise interest rates to slow down the economy—when inflation is a concern. These transactions reintroduce interest rate risks, where your existing fixed income investments lose value.
Opportunity Cost and Systematic Risks
Fixed income securities are subject to opportunity cost risks, which are associated with missed profits from competing investments. Minimal bond interest payments are even less attractive when the stock market performs well. Long-term credit market investors may not benefit from bull markets that enable shareholders to become independently wealthy.
Systematic risk refers to the failure of the entire financial system. Systematic risk ignites credit crises—where banks refuse to make loans and demand that outstanding debt is repaid immediately. This scenario will also cause many fixed income investments to crash, or lose significant value.