Fixed-Income Investment

A fixed-income investment (also known as a 'debt instrument') is essentially a loan made by an investor to a borrower, such as a corporation or government. In return for your cash, the borrower promises to pay you, the investor, a series of predictable, fixed interest payments over a set period. These regular payments are known as the `coupon`. At the end of the loan's term, on what's called the `maturity date`, the borrower repays the original amount of the loan, known as the `principal`. The most common example is a `bond`. Unlike `equity` (stock) ownership, which represents a slice of ownership in a company, a fixed-income investment represents a claim on the borrower's cash flows. Think of it this way: as a bondholder, you're a lender; as a stockholder, you're an owner. For investors seeking a steady stream of income and lower volatility compared to the stock market, fixed-income securities are a foundational component of a balanced `portfolio`.

Imagine you lend your friend €1,000 to help start a small business. Your friend agrees to pay you €50 every year for five years as a “thank you” fee, and at the end of the five years, they'll give you your original €1,000 back. Congratulations, you've just structured a simple fixed-income investment! In the world of finance, it works the same way, just on a much larger scale. The key players and terms are:

• The Issuer: This is the borrower. It could be a national government (like the U.S. Treasury or German government), a city, or a major corporation like Apple or Volkswagen. They issue bonds to raise money for projects, operations, or refinancing debt.
• The Principal: Also called `par value` or face value, this is the amount you lend the issuer. It's the amount you get back when the bond matures.
• The Coupon: This is the fixed interest payment you receive, typically paid semi-annually or annually. It's usually expressed as a percentage of the principal. A €1,000 bond with a 5% coupon pays €50 per year.
• The Maturity Date: This is the future date when the issuer must repay the principal. Maturities can range from a few months to 30 years or more.

While bonds are the poster child for fixed income, the family is quite large. Here are the main types you'll encounter:

These are issued by national governments to fund their spending. In the U.S., these are called Treasuries and come in a few flavors:

• `Treasury bills` (T-bills): Short-term, with maturities of one year or less.
• `Treasury notes` (T-notes): Medium-term, with maturities from two to ten years.
• Treasury bonds (T-bonds): Long-term, with maturities over ten years.

Government bonds from stable, developed countries (like U.S. Treasuries or German Bunds) are generally considered to have very low `credit risk`, as major governments are highly unlikely to default on their debt.

Companies issue `corporate bonds` to raise capital for things like building new factories, research, or acquisitions. They typically offer a higher `yield` (return) than government bonds to compensate investors for taking on more risk. The creditworthiness of the company is a crucial factor here.

Known as “munis,” these are issued by states, cities, counties, or other local authorities to fund public projects like schools, bridges, and hospitals. In the United States, a key feature of `municipal bonds` is that the income they generate is often exempt from federal taxes, and sometimes state and local taxes, too.

The category also includes:

• `Certificates of Deposit` (CDs): These are savings certificates with a fixed maturity date and specified interest rate, issued by banks.
• `Preferred Stock`: A hybrid security that has features of both stocks and bonds. It pays a fixed dividend, similar to a bond's coupon, but it is technically a form of equity.

Even for an investor focused on the long-term growth of stocks, fixed-income securities play a vital defensive role.

The predictable coupon payments provide a steady, reliable income stream, which can be especially valuable for retirees. Because their prices tend to be more stable than stocks, they act as a calming influence on your portfolio's overall value during turbulent market swings.

This is a critical benefit. The prices of high-quality bonds often move in the opposite direction of stocks. When the stock market panics and prices fall, investors often flee to the perceived safety of government bonds, pushing their prices up. This negative correlation provides powerful `diversification`, smoothing out your portfolio's returns over time.

Your primary goal with a portion of your portfolio might be simply not to lose it. High-quality, short-term government bonds are one of the best tools for the job, serving as a safe haven for capital you can't afford to risk.

The “fixed” in fixed-income refers to the payment, not the investment's value. These investments are not risk-free.

This is the big one. If you buy a 10-year bond with a 3% coupon, and a year later, new bonds are being issued with 5% coupons, your 3% bond suddenly looks less attractive. To sell it before maturity, you'd have to offer it at a discount. In short: when interest rates rise, the market price of existing bonds falls.

Your bond might pay you a fixed 4% every year, but if `inflation` is running at 5%, the real purchasing power of your money is actually decreasing. The fixed payments may not be enough to keep pace with the rising cost of living, especially with long-term bonds.

This is the risk that the issuer gets into financial trouble and cannot make its promised payments or repay the principal at maturity. While negligible for a government like the U.S., it's a very real concern for corporate bonds, especially those from less stable companies (often called “high-yield” or “junk” bonds).

The legendary father of value investing, `Benjamin Graham`, advocated for a simple `asset allocation` for the “defensive investor,” which always included a significant portion in high-grade bonds. For a value investor, buying a bond isn't about speculating on future interest rate movements. It's about conducting a sober analysis of the issuer's ability to pay its debts and determining if the yield offered is a fair compensation for the risks involved. The goal is to secure a predictable return and, above all, avoid a permanent loss of capital. This means sticking to high-quality issuers and being wary of the allure of high yields from risky borrowers. A bond is a promise, and a value investor's job is to carefully assess how likely that promise is to be kept.