Fixed income instruments provide regular income payments over time, usually in the form of debt securities like bonds. Retirees often use them for supplemental income. Bonds are a form of debt where a creditor loans money to the issuer and charges interest. Preferred stocks pay fixed dividends, but their value fluctuates. Investors face risks of insolvency and inflation.
Fixed income instruments are securities in which an investor receives regular income payments over a period of time. Fixed income instruments generally take the form of debt securities, such as bonds, although some stocks that pay dividends also pay a fixed income. Retirees often use income instruments to generate supplemental monthly income.
Bonds are a form of debt in which a creditor loans money to the debt issuer and charges the debt issuer monthly or yearly interest. Governments issue bonds to raise money for public projects, such as building roads or new schools, while corporations issue bonds to raise the revenue needed for mergers and acquisitions. Bond terms typically last at least six months, although national governments issue bonds that last up to 30 years. Long-term bonds pay lower interest rates, but appeal to people looking for predictable payments over long periods of time. In the United States, payments from the proceeds of municipal bonds are not taxed at the federal level, making the bonds especially attractive to investors with high tax brackets.
Common shares are not considered fixed income instruments because their value fluctuates daily and dividend payments are subject to change. Many large companies issue preferred stock, which pays fixed dividends. Preferred stock dividends are normally taxable. To make stocks an attractive investment, dividend payments on preferred stocks are generally higher than the yields paid on bonds.
Investors buying fixed income instruments are exposed to a variety of different risks, including the risk of insolvency, as an issuer of government or corporate bonds can only continue to make regular income payments as long as it remains solvent. If a bond-issuing entity goes bankrupt, bond payments generally cease. Many bondholders eventually receive a portion of their investment, but the loss of income can be problematic. When a corporation fails, preferred shareholders can claim a portion of the bankrupt company’s assets, but only after taxes, payroll, and debts have been settled. Preferred stock often loses value after a company becomes insolvent, and many investors lose both a source of income and their original investment.
People who are highly dependent on fixed income instruments also have to deal with inflation risk. Prices tend to rise over time, causing the cost of living to rise steadily over long periods of time. Fixed income payments remain unchanged, meaning inflation erodes investors’ purchasing power. Some investors prefer to buy investments that offer variable rates, such as variable rate certificates of deposit, but while these investments do not expose individuals to the risk of inflation, investors cannot predict income payments from one month to the next.
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