Fixed income investment options include products such as bank certificates of deposit and bonds issued by government entities and corporations. Considerations when choosing investments for the fixed income portion of a portfolio involve comparing yields or interest rates with the factors that may affect the safety of the invested principal. Bond investing strategies attempt to balance earning a higher yield with potential risks.
Interest Rates vs. Term
In most common interest rate environments, the longer the term of a fixed income security, the higher the yield it pays. Investors are getting paid more for tying up money for a longer period of time. Higher rates or yields for longer maturities is called a normal yield curve. During the rare periods of time when short rates are higher than longer-term yields, the yield curve is described as inverted. An investor's decisions of where on the yield curve he wants to invest is a major factor in the total return of a fixed income portfolio.
Strategies for Rising or Falling Rates
If interest rates are expected to decline, an investor would want to buy longer-term bonds to lock in the current, higher rates. Falling rates will also cause bond prices to increase, which could allow a shorter-term investor to generate capital gains as well as interest income by buying long-term securities. If interest rates are forecast to increase, investors focus on shorter-term bonds. These bonds will mature sooner and the money can be reinvested at the new, higher rates. The market price of a short-term bond will not decline much from higher rates since the face value will soon be paid to the bond holder.
Rating Fixed Income Safety
The issuers of bonds and other fixed income securities receive credit ratings that indicate a probability of continued payment of interest and principal. Federal government-issued or agency-guaranteed investments -- such as Treasury bonds and FDIC-insured CDs -- are the safest fixed income investments and typically pay the lowest yields. Securities from investment grade issuers are viewed as having a high degree of safety and very low chance of default. These bonds will pay yields higher than government guaranteed securities. The lowest level of safety comes from non-investment grade issuers, which sell what are commonly called high-yield or "junk" bonds. A lower credit rating means that these issuers must pay higher yields to attract investors. Bond investors must decide where along the risk vs. yield spectrum to buy fixed income investments.
Consider After-Tax Returns
An investor's tax bracket and expected after-tax return can affect his bond buying strategy. Municipal bonds issued by state and local governments pay interest that is exempt from federal and possibly state income tax. Consider the investor living in a high-tax-rate state with a combined federal and state marginal tax rate of 50 percent. If a municipal bond from his home state pays 4 percent, that yield is the equivalent of earning 8 percent from a bond paying taxable interest. Part of any bond investment strategy will be to compare muni and taxable bonds of the same credit quality to find the higher after-tax yield.
A Pair of Portfolio Strategies
A portfolio of bonds may be constructed using one of two strategies that allow for changing interest rates in either direction. With a ladder portfolio, an equal amount of bonds is purchased at equally spaced maturity dates, such as two-, four-, six-, eight- and 10-year bonds. Then as the shortest-term bonds mature, the money is used to buy the longest term in the ladder, since every rung has shortened by the amount of maturity spacing. A barbell strategy involves splitting the portfolio into just long- and short-term bonds. The long end of the barbell earns the highest current rate in the market, and the short end provides the flexibility to either stay short if rates are rising or invest in longer maturities to lock in higher yields if the rate increase seems to have peaked.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.