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Investing in Fixed Income: The Risks

Fixed-income securities represent a huge portion of the financial investing market. That's because they are ideal for retirement and pension plan portfolios as they are deemed low risk compared to the stock market. In essence, fixed-income securities provide a return in the form of a fixed, yet periodic payment until the term expires. They are also known as a bond or money market security and are effectively a loan to a company or government, in which the borrower pays you a set amount of interest until a predetermined set date.

This sounds great in theory because you know what return you are going to receive from investing into the fixed-income product. However, there are three big risks every investor should know about fixed-income securities and we detail them all below:

Interest rate risk

Interest rates and bond prices have an inverse price relationship. Essentially, when interest rates fall the price of bonds, and fixed-income securities, generally tend to rise. Of course, the opposite is true also as when interest rates rise the price of bonds, and fixed-income securities, generally tend to fall. So why is this?

Well, when interest rates start to fall, or investors believe interest rates will fall, then they need to lock in the highest rates possible so they can still grow their capital for as long as possible.

Therefore, investors would tend to flock to the fixed-income securities that pay the highest interest rate in the marketplace and one that is, hopefully, much higher than the market interest rate at that moment in time. That leads to a huge surge in demand which increases the base price of the security.

So, when investing into fixed-income securities an investor needs to keep an eye on where overall interest rates are going. If an investor buys a bond which pays 4% interest, then when the market interest rates gets to 4% the price of the bond will be lower. Therefore, if the investor wanted to sell the bond then he will have to do so at a lower price.

Inflation risk

An investor of a fixed-income product does so because they want to receive a fixed rate of return for the as long as the product is held. However, inflation can massively eat into any gains that are made.

That's because inflation, the measure of the change in the value of goods and services, can decrease an investors purchasing power.

In essence, if inflation was on the rise, causing the cost of living to increase then there could be a point where the inflation rate is bigger than the rate of return causing an actual loss for the investor.

For example, if investing into a fixed-income security that pays a 2% rate of return and inflation suddenly moved higher to 3%, then the person investing is actually receiving a negative true rate of return (2% - 3%) of -1%.

Credit risk

When investing into fixed-income securities the investor is essentially lending money to a company or government (the person who has issued the bond). Therefore, the investor is actually buying a 'certificate of debt'.

This means that the borrowed money has to be repaid, with interest, over a set amount of time. However, when investing into corporate bonds they aren't guaranteed by the full faith and credit of the government and actually only depend on the corporate entity's ability to repay that debt back.

That means investing into high investment grade fixed-income securities is the safest way to do so but can still carry some inherent risk. Many investors look to government bonds as a safer way to purchase fixed-income products. However, it depends on which government is issuing the bond so it's important for any investor to do their due diligence and background homework.

There you have it folks, the three biggest risks of fixed-income investing. Regardless of these, they are still deemed much safer than many other types of investments so it's important to know your risk tolerance before investing.
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