Fixed Income Investing

Deciding how to allocate your retirement assets between stocks and fixed income funds is one of the most important decisions an investor can make. In fact, some studies have shown that the decision on the percentage of each asset class in the portfolio determines more about the investor’s ultimate performance than the specific choice of investment.

By including fixed income investments in a portfolio, investors can attempt to smooth out its volatility because, in general, bonds and stocks tend to rise and fall on different cycles. When this occurs, bonds can reduce the impact of a fall in stock prices.

Most investors understand that equity investments are based on the performance of the company whose shares are being purchased. an equity mutual fund performs well when the companies in the portfolio do well and is less successful when the companies do not earn profits.

Fixed income funds are somewhat more complicated and investors need to understand the factors underlying their performance. Basically, fixed income securities are debt from a government or corporation that provides a steady stream of income and the return of the face (or principal) amount. For example, a 5% rate of interest on a $1,000 bond would pay $50 per year in interest. When the bond matures, the owner would receive back the $1,000 principal. However, if the bond is sold before maturity, its value could be higher or lower than the price paid.

Since there are also a variety of fixed income investment options, it’s also important to know how the different types of fixed income investments act under varying economic conditions. Here is a brief look at several fixed income funds.

Money Market Funds

Money market funds typically invest in U.S. Treasury bills, and other short-term fixed income assets from high-quality corporations, such as commercial paper, repurchase agreements, and similar assets. The objective of a money market fund is typically to provide a rate of income that is approximately equal to current market short term rates, without any change (increase or decrease) in investors’ principal value. Though money market funds rarely show fluctuation in investors’ principal value, there is no guarantee that the price will remain stable. Because of the reduced risk of loss in a money market fund, the expected rate of return over a market cycle is less than other fixed income investments.

Stable Value Funds

In general, the objective of stable value investments is typically to provide a higher rate of income over a complete interest rate cycle than do money market funds, with the same principal stability of money market funds. Stable value funds are typically able to provide a higher income rate over a complete market cycle because they are able to invest in both a wider variety of fixed income assets and invest in assets with longer maturities than do money market funds. Stable value funds also use financial guaranty contracts, often purchased from insurance companies, to provide investors with daily liquidity and principal stability.

It is important to note that because stable value funds rely on securities that come due over longer periods than the securities in a money market fund, money market fund income rates will increase and decrease faster than will stable value fund income rates.

Total Return Bond Funds

A total return bond fund is simply a bond fund that, unlike money market funds and stable value funds, will have changes in principal value as well as produce income. Typically, as market interest rates rise, the principal value of fixed income securities will decrease. As market interest rates decrease, the principal value of fixed income securities will typically increase. That means that an investor can lose money in a bond fund if decreases in the principal value of underlying investments are greater than the income generated. It also means that investors can enjoy a principal value gain in a bond fund in addition to receiving income, if the principal value of the underlying bonds increases.