The primary goal of fixed income investments is indeed to generate income, particularly income that can be used for day-to-day financial management. This distinguishes investments in the income class, such as bonds and preferred shares, from a fixed income investment strategy that involves owning investments in the fixed income class and utilizing the income generated by those investments.
Fixed income investments, including bonds, preferred shares, savings instruments like certificates of deposit, and other income-focused savings investments, provide a fixed level of interest income. However, the value of these investments can vary in the market. Unlike savings instruments, fixed income investments can be traded, allowing investors to potentially sell them at a profit or cover their positions at a lower price to achieve capital gains.
The goals of investing for income are similar for both savings instruments and fixed income investments, which is to generate income for the investor. Investors may choose to trade fixed income securities to capture capital gains or focus on the interest income over time. Some investors may employ a hybrid strategy to seek both capital gains and interest income, aiming to increase the overall value of their portfolios.
While the focus on fixed income results may be more prominent in the later years of one’s career, as retirement approaches, it is not limited to that stage. Investors can invest with a view toward generating income even before retirement, while also considering the growth of their portfolios as a priority.
Mitigating the Primary Risk in Fixed Income Strategies: Falling Short of Income Goals
Placing a majority of our portfolio in fixed income investments with the intention of using the earned interest as income involves sacrificing some potential for growth in exchange for more predictable and reliable returns. Growth-oriented investments like stocks historically deliver higher average annual returns compared to fixed income securities. Therefore, it often makes more sense to pursue fixed income strategies in the later years of our working career when we are closer to needing a stable income and have a shorter time horizon to take advantage of growth investments.
Ideally, our portfolio will have grown sufficiently over time to allow us to allocate more to fixed income investments and generate enough income for a comfortable retirement. The success of this strategy depends on our ability to grow our portfolio and accumulate enough assets to provide the desired income in the future.
Managing returns and risk is crucial at every stage of investing, including the early years. Developing a solid plan that balances growth and risk can help us reach a point where our efforts generate income to enhance our financial security, whether it’s during retirement or for other financial goals.
If retirement savings is the primary objective, we may choose to continue investing in the stock market and utilize dividends, capital gains, or even spend down our capital to meet our income needs. Alternatively, as retirement approaches, we may gradually shift towards fixed income investments to prioritize stable income.
One of the significant risks in a fixed income strategy is not having enough accumulated investments when we need them to generate the desired income. Mitigating this risk involves saving diligently and considering potentially more aggressive investment strategies if necessary, while carefully managing the associated increased risks. Balancing potential returns and risks is essential to align our investment approach with our income goals and risk tolerance.
Market risk can still be a concern with fixed income investments if we need to sell them during a market downturn or before maturity. If we have to access the principal to supplement our income, the value of the investments at the time of sale becomes crucial.
One potential risk is the need to draw down against the principal of our investments due to unforeseen expenses or the income generated by our investments not keeping pace with inflation. In such cases, we may be exposed to the market risk associated with fixed income investments, particularly if interest rates have increased since the time of purchase.
The value of fixed income investments is inversely related to interest rates. As interest rates rise, the relative value of existing fixed income investments decreases because the interest they pay becomes less attractive compared to newer investments with higher interest rates. This can result in a decline in the market value of the fixed income investments.
When selling fixed income investments in a rising interest rate environment, one may have to sell them at a lower price than their original value to make the lower interest rate attractive to potential buyers. Selling at a loss can further compound the challenge, especially if the proceeds are needed for living expenses.
Therefore, it’s important to consider the potential need for liquidating fixed income investments before maturity and assess the potential market risk associated with such actions. Fixed income investments are not necessarily buy-and-forget investments, especially if there’s a foreseeable or possible need for premature liquidation. Regular monitoring of market conditions and reassessment of investment strategies may be necessary to align with changing financial circumstances.
Addressing Inflation Risks in Fixed Income Strategies
Over time, as inflation increases, the purchasing power of the fixed interest payments may decline. This is a consideration, especially when investing in longer-term bonds that provide a fixed income for an extended period.
To manage this risk, it’s advisable not to have an excessive portion of your portfolio invested in longer-term bonds, especially if you anticipate significant inflation. While longer-term bonds generally offer higher interest rates, it’s essential to strike a balance between the potential return and the risk of declining purchasing power due to inflation.
The ability to tolerate inflation risk varies from person to person based on individual circumstances and resources. Those with sufficient financial resources to cover a certain level of inflation may be more comfortable holding more long-term securities. However, it’s crucial to assess personal risk tolerance and ensure that the portfolio is appropriately diversified.
Building a larger portfolio over time is indeed beneficial for managing future risks and enhancing the potential success of a fixed income strategy or any strategy aimed at generating income from investments. By saving more, investors can strengthen their financial position and have more flexibility to handle unexpected events or changes in market conditions.
Timing is also important. It’s prudent not to commit to a fixed income strategy too early, allowing the portfolio to grow sufficiently before transitioning to a more income-focused approach. This approach helps mitigate the risk of exposing the portfolio to excessive interest rate or inflation risk too soon.
By having a well-thought-out plan and executing it effectively, investors can maximize the benefits of a fixed income strategy in their later years while managing potential risks along the way.
