There are many different types of fixed-income products, with each offering its own advantages and disadvantages. Treasury securities have provided the majority since 2012 and made up 37% of the fixed-income market in 2019. While they are the most popular, they are far from the only type of fixed-income securities.
Issued by the US Federal Government, treasury bills are a short-term way to invest in fixed-income securities, as they typically mature within one year. Investors buy treasury bills at a rate lower than the face value and earn the difference at maturity.
A treasury note can mature anywhere from two to twenty years and is also issued by the government. These treasury notes are sold in denominations of $100 and provide both principal and interest payments. A treasury note will pay semiannual interest for the duration, and the principal is returned to the investor when it matures.
Treasury bonds are very similar to treasury notes, except they have a much longer duration to maturity. Also purchased in denominations of $100, they don't typically mature for 20-30 years.
TIPS are a fixed-income security that protects the investor from inflation, by adjusting the principle to meet inflation or deflation. TIPS are sold by the US Treasury with maturities of 5, 10, or 30 years and pay interest every six months for their duration. This fixed-income security is capped at $10,000 per year.
The fixed-income securities listed above are issued by the US Federal Government, but state and local governments can issue government bonds as well. These debt obligations are typically taken on by state or local governments to fund projects and are broken down into general obligation bonds or revenue bonds.
General obligation muni bonds are often considered extremely safe because the issuer can raise taxes if they get into fiscal trouble. The same is not true for revenue muni bonds, however, which is why our fixed-income team at Paragon Capital Management, LLC typically does not use them for our clients' portfolios.
From 1970 to 2016 the default rate on 5-year municipal bonds was just 0.07%. These bonds also typically offer preferential federal and state tax treatment, with many offering tax-free interest income (although that can vary by state).
Credit risk is something to consider when seeking corporate bonds as a part of your fixed-income strategy, as the interest rates paid by the issuer will depend largely on their credit ratings.
Higher credit risk companies may issue high-yield bonds (also known as junk bonds) because their lower credit rankings require them to pay higher interest rates to attract investors. On the other side of the coin, investment-grade bonds come from companies with very low credit risk, but will also pay lower interest rates.
Financial institutions may offer Certificates of Deposit (CDs). With maturity rates of five years or less, these investments offer greater interest rates than a savings account or money market funds (but a lower interest rate than many investments that you will find in the bond market) and also carry Federal Deposit Insurance Corporation (FDIC) protection.
These fixed-income securities face liquidity risk. If you sell a CD before maturity, you will forfeit some or all of your interest.
Banks tend to vastly reduce their lending in times of economic turmoil, which can leave middle-market businesses seeking a way to raise money. There are approximately 200,000 middle-market businesses that have $10 million to $1 billion in annual revenue and need ways to raise capital when the banks aren't lending.
Private credit allows institutional investors to service those funding needs. These types of fixed-income securities are less liquid and may have a lock-up provision, but typically have a higher targeted distribution rate than public bonds.
At Paragon Capital Management we have access to these types of investments for our clients who meet the investment minimums to join our client list.
Structured notes can be an extremely beneficial part of a diversified portfolio. A typical advisor may suggest retail structured notes for your portfolio, but at Paragon Capital Management, LLC we provide our clients with access to wholesale structured notes, which are substantially different.
Because of our institutional relationships with the largest investment banks, our team is able to build custom-structured notes for our clientele that are hybrids. A hybrid of 80-90% fixed income and 10-20% options or derivatives, these investment vehicles utilize asset-backed securities with payoff profiles built to take advantage of rising, falling, or even range-bound markets.
If you don't know anything about bonds, but still want access to fixed-income products, you can opt to invest in bond funds. These funds are pooled investments (either a bond mutual fund or an exchange-traded fund (ETF)) that invest in bonds and other fixed-income securities.
Some bond funds only invest in investment-grade individual bonds. Others target junk bonds, some focus on municipal bonds, and other bond mutual funds invest wherever they can find the highest yield or the lowest taxes. These bond mutual funds may be actively managed (and may actively participate in the secondary market), while others are passively managed (buy & hold strategy). Some others are focused on taxes and invest in taxable or tax-free municipal bonds.
Fixed-income mutual funds are a good way to diversify if you are a normal investor, but for high-net-worth and accredited investors it is far better to work with a financial advisor who focuses on fixed-income products.
When people hear the term "stock" they usually think of equities or common stock shares. Preferred stock is a hybrid between common shares and bonds, and includes some characteristics of each asset class. These shares are ranked above common stock but below bonds in the event of a liquidation.
Preferred stock is typically paid through a fixed-rate dividend payment, which is often higher than the dividend paid on the same company's common stock. Different companies will issue preferred stock that will pay these dividends quarterly or monthly, and the dividend may be a fixed rate or adjustable according to a benchmark, often the federal funds rate. These shares can sometimes also be converted into common stock to participate in the upside of positive market activity.
One downside is that while common stock does typically come with voting rights regarding the direction of the company, preferred stock does not. Another downside is that a company is not seen as defaulting if they miss payments of the dividends for its preferred stock. Preferred shares are generally sensitive to interest rate risk, and there is a risk that the company will call in preferred shares (if they have a call provision) if the interest rates drop.
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