Written byThe Inspired Investor Team |Published onApril 13, 2023
When seeking higher investment returns, fixed income is often considered the tortoise and equities the hare.So why consider fixed-income investments like bonds, guaranteed investment securities (GICs) or money market securities in your portfolio? The main reason: Diversification. Within a diversified portfolio, fixed-income investments can help reduce volatility, particularly when stock markets decline.
Historically, fixed-income investments such as bonds have provided a higher return than cash investments and have exhibited less volatility than stocks. In times of equity market downturns, fixed income may help to offset the negative returns on stocks while lowering the overall risk of your portfolio. Fixed-income investments can also be an option for investors seeking regular cash flow.
Are they right for you? Read on to learn about some of the key benefits of fixed-income investments, plus potential risk factors, when considering adding them to your portfolio.
Key benefits
Income:Most bonds pay interest semi-annually; however, some bonds pay monthly, quarterly or even on an annual basis. These payments provide you with regular and predictable income. This regular income stream can also help to reduce the volatility of your portfolio’s returns.
Safety:The highest quality bonds are those issued by the Government of Canada. Many provincial and some corporate bonds also provide a high degree of safety. Although any bond can decline in value, you can feel confident that you will receive full repayment of principal plus interest if you hold high-quality bonds to maturity.
Variety:Many kinds of fixed-income products are available, from guaranteed investment certificates (GICs) and treasury bills to government, provincial and corporate bonds. You can also purchase strip bonds, real return bonds, step-up bonds, Eurobonds and many U.S. instruments.
Convenience:You can purchase GICs, bonds and other fixed-income investments online just as easily as you would stocks. You can also gain fixed-income exposure through a variety of mutual funds and exchange-traded funds, also available online.
Although fixed-income investments have proven to be less volatile than equities over time, there are still risks to investing in fixed income. Bond prices can go down, and issuers can default. Here are some of the main risks of fixed-income investments to consider:
Interest Rate Risk
Fluctuations in interest rates can prove challenging for bonds. Bond prices tend to have an inverse relationship with interest rates- when interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. Interest rate risk generally refers to the risk ofrising interest ratesand areduction in themarket value of a bond. Securities with a longer maturity date and a lower coupon (interest) rate will be more sensitive to changes in market interest rates.
Somegood news is thatwhile existing bond prices may decline, reinvesting coupon income at higher interest rates could work in your favour over the long term. Rising interest rates can also make new bonds more attractive because they are offered at ahigher coupon rate.
Duration Risk
Duration measures a bond's sensitivity (or how much a bond is likely to fluctuate in price) toa one percentchange in interest rates in either direction.Duration risk, therefore,specifically relates to how much a bond's price can be expected tofall as per a 1% increase in interest rates.While duration is stated as a measure of time (years) it isan important factor in the world of fixed income, as it is often used tocompare a bond to a benchmark orsimilar bonds when assessing risk. Generally, the higher the duration number, the more sensitive a bond investment is to a change in interest rates.
Default or Credit Risk
The risk is thata bond issuer becomes insolvent or unable to service its debt obligations (make coupon payments or repay the principal of the bond) in a timely manner. This can lead to a partial or total loss of an investment.Generally, bonds with a lower credit rating by rating agencies such as Standard & Poors and Moody's have a higher potential fordefault. For example, credit risk is more often associated with high-yield bonds as these bonds have lower credit ratings and correspondingly higher risk.
Credit risk, however,also applies to investment grade bonds as rating agencies are continuallyevaluating the creditworthiness of fixed income issuers and theratings they assign are subject to revision at any time. A rating agency may issue warnings or place an issuer undercredit watch which usually leads to a decline ina bond'smarket value and/or a future downgrade ina bond'srating.
Diversification of fixed-income investments by issuer type (government and corporate), and by issuer (different levels of Canadian government, international governments, companies operating in different sectors) can help to minimize credit risk.
InflationRisk
The risk is that the yield on a bond will not keep pace with purchasing power,resulting in lower return expectations. This happens because inflationerodes the purchasing power ofcash flows asthe coupon payments and principal received from most fixed income products are not adjusted to account for inflation. This means thatif inflation is high, you willbe able to buy less with the money you receive. Real return bonds, which are issued by the Government of Canada, and some provinces, can be a solution as their cash flows are indexed (adjusted) to inflation.
Reinvestment Risk
If you are investing to accumulate wealth (that is, planning to reinvest interest payments received) rather than generate current income, then reinvestment risk becomes an important factor. Future coupons must be reinvested at the prevailing market rate, so changes in this reinvestment rate will positively or negatively affect the compounded yield to maturity of your investments. Also, some bonds carry a “call” feature, which allows the issuer to redeem the bond prior to maturity after a certain date if conditions are met. In this case reinvestment risk is higher because you may have to reinvest the principal earlier than anticipated.
Liquidity Risk
Fixed income is often, but not always, quite liquid. This means that sellers are generally able to find buyers willing to buy bonds at or near the market price. Liquidity, however, is usually not guaranteed. This means that in some instances fixed-income holders may have difficulty finding buyers, or might have to sell at a significant discount.
Find out more about fixed-income offerings at RBC Direct Investing in Fixed Income FAQs. To search for fixed-income investments, log in and go to Research on the site menu. Select Research Tools then click on Fixed Income.
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