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-inome 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?

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. 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 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 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

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 portfolio. 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.

• Bond Funds
• Bonds
• Preferred Stock
• Mortgages

Additional Resources

Dear Susan

MSN