Fixed Income Securities & Risks
Fixed income, or credit securities, are loans made between investors and corporate and government institutions. In exchange, investors receive fixed interest payments until loan principal is repaid at maturity.
Creditor asset claims are senior to those of shareholders, which means that bond interest payments will be prioritized in the event of bankruptcy. For this, conservative savers prefer credit securities. All investment decisions, of course, do present distinct risks.
Credit risk describes the ability to pay down debt in full. Standard and Poor’s, Moody’s, and Fitch are the Big Three agencies that control a combined 95% of the global credit rating market. Mutual funds, pensions, and government treasuries all reference credit ratings before committing to capital allocation decisions.
Investors will demand higher interest payments for lesser rated securities. Junk bonds on corporations teetering upon the brink of collapse may offer more than ten percent current yield. Credit risk is elevated amid recession and financial crises.
Interest Rate Risks
Fixed income securities lose value when interest rates rise. In this environment, newer credit securities will pay out more interest relative to the existing securities already out in circulation. Old bonds must then sell at a steep discount to attract and compensate investors for meager interest payments.
The Federal Reserve has already signaled its intent to raise rates aggressively in response to white hot inflation. The bond market has responded in kind – with 10% year-to-date losses.
Inflation is a one-two combination deathblow to conservative savers. Firstly, inflation devastates purchasing power for principal and interest payments. Next, inflation forces the hand of the Federal Reserve to drive rates higher and cool the economy. Fixed income securities will then lose significant value.
Opportunity cost risks, or FOMO, describe the failure to participate in the profitability of competing investments. Bond interest payments appear even less attractive when juxtaposed against impressive stock market returns.