Understanding the Basics: Fixed Income

What is fixed income?

Aside from stocks and crypto, there are even more ways you can invest your money! One other way is fixed income. Fixed income is a form of investment where you receive scheduled, set payments from an entity. For example, if you invest $1000 into an entity and the interest rate is 5% over ten years, every year you receive $50. So, after ten years, you receive all of the interest you have collected ($500), and you get your original payment back ($1000). By investing in fixed income, you are giving the entity a loan where they agree to pay back the face value of the loan and interest payments on set, scheduled dates.

Different kinds of fixed income

The first kind of fixed income you’ll learn about are treasury bills. Treasury bills are issued by the government with a maturity of one year or less. The difference between regular fixed income and a treasury bill is that a treasury bill does not pay you interest on your loan. Instead, you buy a treasury bill at a discounted price. For example, you can buy a $1000 treasury bill with a 6-month maturity at a discounted price of $950. After 6 months goes by, you are paid back the $1000, making a $50 profit.

Next, let's learn about a certificate of deposit. Unlike treasury bills, a certificate of deposit focuses strictly on interest. Once you leave your money with a bank for a set term, you cannot take the money out until the time is up. Also, another benefit of a certificate of deposit is that the interest compounds on top of itself. For example, invest in a 3-year $5000 certificate of deposit with a 5% annual interest rate. After the first year, you make $250 ($5000 x .05 = $250). Then, after the second year, you make $262.50 ($5250 x .05 = $262.50). Finally, after the third year, you make $275.63 ($5512.50 x .05 = $275.63). As you can see, instead of making $250 every year, you make more and more each year. Now let's get even deeper. There are 4 types of certificates of deposit:

• Traditional certificates of deposit: Fixed term and fixed interest rate.

• No-Penalty certificate of deposit: Allows you to withdraw your money without penalty.

• Bump-Up certificate of deposit: If general interest rates go up, the interest rate on your certificate of deposit will go up.

• Jumbo certificate of deposit: Necessitates a humongous investment, but offers higher interest.

  
  

Finally, let's look at money market funds. A money market fund is a version of a mutual fund that invests into fixed income securities like certificates of deposit and treasury bills! Instead of investing into fixed income securities yourself, a money market fund will do it for you. Money market funds were created so people could pull out money from their fixed income at any time. So, if you wanted to take your money out after 1 year but your interest hadn’t been collected, it does not matter, and you are still free to do so. Also, money market funds are known to be safer and less risky than individual fixed income securities.

Bad vs Good Fixed Income

Although all fixed income sounds like sunshine and rainbows, there are some elements of bad fixed income. First, let’s talk about risk based on credit. If an entity has a high credit, like the US government, people are more likely to trust and invest in it, unlike entities with lower credit. A lower credit means there is a higher chance the entity won’t pay you your loan back.

Next, we’ll look at maturity. Maturity measures how long your fixed income lasts. Entities with flexible and shorter maturity are easier to trust because they only hold your money for a short amount of time. An entity with a long maturity is more risky because they are prone to being affected by higher interest rates. This could make your fixed income less valuable against the market.

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Tell us your favorite fixed income in the comments!