Investing in fixed-income securities

The appeal of fixed-income securities is that they offer the potential for a steady stream of income, with changes in their principal value being generally less volatile than that of other investments.  However, as with all financial assets, ownership of fixed-income securities entails a variety of risks that accompany the possible rewards.

Main types of fixed income securities:

• Certificates of deposit (CDs): CDs are like promissory notes. When you invest in a CD, you agree to hold that investment for a set period of time, in exchange for a fixed interest rate. The types of CDs available through TD AMERITRADE are called brokered CDs. They are similar to CDs purchased directly from a bank, except they can be traded on the open market.
  
  This means you can sell the CD before its maturity date and avoid paying "early withdrawal" penalties. However, brokered CDs that you choose to sell prior to maturity in a secondary market may result in loss of principal due to fluctuation of interest rates, lack of liquidity, or transaction costs.
  Read more about CDs. 
  
  
• Treasury bonds: These are issued by the U.S. government and are generally considered a very safe investment. However, the government guarantee only applies to repayment of principal and interest earned if held to maturity and these securities remain subject to market and interest rate risk if sold prior to maturity. Interest earned from these investments is exempt from state and local taxes, though it is subject to federal taxation. Because their risk is considered low, the bonds usually earn lower interest than other kinds of fixed-income securities.
  Read more about U.S. Treasury securities.
  
  
• Corporate bonds: Corporate bonds are issued by companies. The risk of investing in these bonds varies based on the credit rating of the company that issued them. This is known as credit risk - the issuing company's ability to repay its obligations. Corporate bonds usually earn higher interest than CDs or government-backed bonds with the same maturity but can experience greater price volatility.
  Read more about corporate bonds.
  
  
• Municipal bonds: These are issued by states, their agencies and subdivisions (i.e., counties and municipalities). There are two main categories of municipal bonds (or "munis" as they are sometimes called):
  

  • General obligation bonds are backed by the issuer's power to tax. If the issuer needs funds to pay interest or repay the debt at maturity, it can tax its citizens to raise the necessary funds. General obligation bonds are considered the safest type of munis.
    
    
  • Revenue bonds are backed by revenue from the project built with the proceeds of the bond sale. For example, a city might issue revenue bonds to construct a toll bridge. The toll revenue would then be used to pay interest and repay principal at maturity. Revenue bonds are considered less secure than general obligation bonds because the revenue might be insufficient to make these payments.

  Read more about municipal bonds.

  Interest income on Municipal Bonds may be subject to the Alternative Minimum Tax and state and local taxes. Discount bonds may be subject to capital gains tax.

• Agency bonds: Agency bonds are issued by federally-sponsored agencies, such as Freddie Mac and Fannie Mae, though these investments are not guaranteed by the U.S. government. The risk of investing in these bonds varies based on the agency that issued them (credit risk).
  Read more about agency bonds.
  
  
• Zero coupon bonds: Zero coupon bonds are issued by the federal government or by a municipal government; but unlike other government bonds, investors receive a single payment when the bond matures, but no periodic interest payments prior to that.
  Read more about zero coupon bonds.

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Bonds are subject to several types of risk

• Financial (or Credit) risk: The financial health of the issuer is an important influence on the value of its fixed-income securities. The credit ratings assigned by the major rating agencies, such as Moody's Investors Services and Standard & Poor’s Corp., are widely accepted measures of the credit risk of a particular security.  Accordingly, a change in the credit rating of an issuer (or the expectation of a change) would generally affect the price of its bonds.  A credit downgrade would be viewed as a negative and would tend to decrease the price of a bond; similarly, a credit upgrade would tend to raise the price of the bond.
  
  Determining the appropriate level of credit risk for a portfolio depends largely on the situation of the particular investor. Generally, for an investor who is concerned with preservation of capital, high credit quality should be a priority.

• Liquidity (or Market) risk: Liquidity risk refers to the risk that an investor may not be able to sell a security quickly at is fair value.  Investors should be aware of the liquidity risk of the market as a whole, in addition to the liquidity risk of particular securities.  Even though the liquidity of a particular issue may be high, at times the market itself may be less liquid.

• Interest rate risk: The basic relationship that holds true for most fixed-income securities is that price moves in the opposite direction of interest rates.  For example, when interest rates rise, the price of the security will fall.  Conversely, when interest rates decline, the price of the security will rise.  This risk is commonly referred to as market, or interest rate risk.
  

  The price sensitivity for a particular security to a change in interest rates depends largely on characteristics such as the coupon, the maturity date, and all call features. The most common measure of price sensitivity is duration.  Duration equals the weighted-average term to maturity of all cash flows.  The weight assigned to a particular cash flow is determined by computing its present value in relation to the present value of all the security's cash flows.  Essentially, the greater duration of the security, the greater its price sensitivity.
  
  

  The degree of price sensitivity depends largely on the duration of the security.  The longer the maturity of the security, the greater the sensitivity of its price to changes in interest rates, other things being equal.
  
  

  The price sensitivity of the fixed-income security to changes in interest rates is greater for securities with lower coupons.  Essentially, the duration of a lower-coupon security is greater than for a high coupon security.

• Call risk: Fixed-income securities are often issued with a call provision.  From the investor’s perspective, there are three major disadvantages associated with a call provision.  First, the cash flow stream is not known with certainty.  From the investment strategy standpoint, this creates a problem with identifying the proper time horizon.  Since a security is callable before maturity, the actual duration of it is less than its duration to maturity, but more than its duration to call.

  Another disadvantage associated with callable securities is that the issuer will generally call bonds when interest rates have declined, leaving the investor to reinvest the proceeds at an inopportune time.  Finally, the price appreciation of “callables” is limited since the price of a callable issue does not rise much above its call price.  Unfortunately, the same is not true for the downside price risk.  The price of a callable issue can fall far below its call price given a substantial rise in interest rates.

• Re-investment risk: Re-investment risk refers to the risk that interest payments and re-payment of principal would need to be re-invested in a low interest-rate environment, and, therefore, give the investor a lower total rate of return than might have been expected when the security was originally purchased.
  
  The income received from the re-investment of coupon payments can be an important element in the total return from a security, particularly long-term issues.
  
  
• Inflation (or purchasing power) risk:  Most fixed-income securities are designed to provide a stream of interest payments over time, plus the return of your principal at maturity.  The drawback, however, is that you do not know what the purchasing power of those payments will be in the future.  This risk is commonly referred to as inflation risk.  Inflation risk is the likelihood that inflation will erode the value of those payments over time.  A rise in inflation would generally push up yields and reduce the price of the security.
  

  Inflation risk is higher the longer the maturity of the fixed-income security.  One way to counteract inflation risk is to stagger maturities or build a portfolio ladder.  With a ladder, maturing funds can be re-invested as they mature.  If inflation rises, yields are likely to rise as well, so the maturing funds can be re-invested at higher yields.

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Fixed-income portfolio structure disciplines

Other Strategies: Within any portfolio discipline there are various strategies that can be used to meet financial objectives or to increase portfolio performance.  Some of these strategies are appropriate for all investors, while some may not be.

• Swap strategies: There are several ways to use swap methods to help take advantage of the different market environments.  Some of the methods include pre-refunding swaps, credit swaps, extension swaps, and tax loss swaps.  It is important for investors to consider their investment objectives, risk tolerance and financial situation when selecting a particular strategy.
  
  
• Pre-redemption (Pre-refunding) swaps: A pre-redemption swap is the most straightforward strategy that an investor can employ.  It generally involves selling an issue that is to be refunded within a short period of time and simultaneously investing the proceeds generated from the sale into another security.  Issues approaching refunding dates tend to trade close to their redemption price.
  
  
• Credit swaps: A credit swap involves the exchange of two securities with similar duration characteristics (maturity and coupon), but different credit quality.   In general, the advantage of this strategy is that it allows investors to potentially add yield to their portfolios, while preserving their existing investment horizon. Of course, lower credit quality increases the level of credit risk.
  
  
• Coupon swaps: A coupon swap involves the exchange of two securities from a particular issue that have roughly the same duration characteristics but different coupon rates.  The benefit of this strategy arises from relative differences based upon the supply and demand of securities with various coupon rates, or from differing expectations about the future direction of interest rates.
  
  The underlying premise for a coupon swap is that, other things being equal, the lower the coupon of the security, the more sensitive its price is to changes in interest rates.  Therefore, investors who expect interest rates to decline might consider moving to lower coupon, or discounted issues.  Conversely, if the expectation is for higher interest rates, higher coupon, or premium priced issues would be more appropriate.
  
  
• Duration (Extension) swaps: Duration swaps involve two securities that have different duration (maturity and coupon) characteristics.  This strategy is generally more appropriate for trading strategies.  The objective of this strategy is to extend or reduce the duration of a portfolio according to expected market conditions.  For example, if rates are expected to rise, investors might shorten the duration in their portfolios to help reduce principal risk.  If interest rates are expected to decline, investors might extend the duration of their portfolios to help maximize the total return potential.
  
  
• Tax loss swaps: One other swap strategy that investors can consider is a tax loss swap.  Subject to some restrictions, a tax loss swap can enable an investor to offset capital gains generated elsewhere.  Briefly, an investor who has a capital loss must first offset short-term losses against short-term gains, and then long-term losses against long term gains.  Losses that remain after capital gains are offset can be applied against ordinary income.
  
  A tax loss swap often involves moving to an issue with a higher coupon.  For example, suppose an investor bought a security one year ago when market yields were substantially lower.  The investor can now swap into a more recently issued security that carries a higher coupon rate.  Note than in light of the “wash sale” rule, the new security must be substantially different than the old one.  That means the new security must be from a different issuer or have a substantially different coupon or maturity.
  
  TD AMERITRADE does not provide tax advice. We suggest that you seek the advice of a tax-planning professional with regard to your personal circumstances.
  
  

Once you're familiar with the types of fixed income securities available, you may want to read more about some strategies associated with these kinds of investments. Visit the Path to Investing site. 

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