Fixed Income – Back to Basics
The broad and growing appeal of fixed-income investments has caused an explosion in the type and range of products available. Understanding the vast range of fixed income products can be overwhelming for both new and experienced investors alike.
The best place for most investors to start is at the beginning, with the basics:
What is a fixed-income investment?
A traditional fixed-income investment is a debt obligation - essentially an IOU. The borrower (known as the issuer) promises to pay the investor a specified rate of interest (known as the coupon rate) on a regular basis (typically every six months) for as long as the investor holds the investment, and then repay the principal on a stated maturity date.
Similar to stocks, most debt investments trade in the marketplace and may fluctuate in price. Because the bond market is not readily visible to investors, many do not realize its size. In Canada, the fixed-income market is approximately 40 times larger in trading volume than the equity market.
The value of a fixed-income security is tied to the interest rates and the currency of the country in which it has been issued. When interest rates decrease, the price of a bond generally will increase: the bond's coupon rate becomes more attractive compared to the current market interest rates. In contrast, when interest rates rise, bond prices generally fall. Considering the future trend of interest rates is an important part of understanding fixed-income securities.
Why invest in fixed-income securities?
Fixed-income securities appeal to investors for several reasons:
By diversifying your portfolio with fixed-income securities, you can reduce your investment risk and potentially increase your returns over time.
Fixed-income securities provide a steady stream of income and an issuer-guaranteed pay-back price if held to maturity. In addition, the safety of a fixed-income security is reflected in the credit rating of the issuer.
High-quality fixed-income securities can provide a series of predictable cash flows over a period of time with minimal risk to their invested capital. This feature is essential for budgeting and long-term planning.
The multitude of fixed-income securities available today provides investors with a flexible means to increase the value of their investments.
What are the risks?
When held to maturity, high-quality issues are generally considered conservative investments. Yet, like any investment, fixed-income securities can be subject to certain risks, including that of price fluctuation. This type of risk arises when you sell your fixed-income investment prior to the maturity date. However, that can also work to your advantage.
As mentioned, bond prices and interest rates generally have an inverse relationship: when interest rates rise, prices on existing bonds tend to fall, and when rates fall, bond prices tend to rise. So if you sell a fixed-income investment before the maturity date and interest rates have risen since your original purchase, you may receive less than your original principal. Then again, if interest rates have fallen since that time, the principal you receive back could be higher.
Important considerations for Canadian taxpayers
With any investment, what you get to keep after taxes is more important than what you earn. Canada Revenue Agency has very specific rules governing the tax treatment of the interest paid to you on your fixed-income investments. All payments due to you are considered taxable in the year they are declared, regardless of whether you actually receive the income. Therefore, for investments like stripped bonds, which accrue interest that is not received until maturity, tax planning holds special challenges. Tax-sheltered funds like RRSPs and RRIFs are good vehicles to hold special types of fixed-income securities. You should consult your tax advisor with specific questions about the effects of taxation on your investments.
Make sure to speak with your CIBC Wood Gundy Investment Advisor to find out if fixed income investments are appropriate for you and your long-term financial plans.
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