Fixed income instruments are securities on which an investor receives regular income payments for a period of time. Typically, fixed income instruments take the form of debt securities, such as bonds, although some dividend paying stocks 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 annual interest. Governments issue bonds to raise money for public projects, such as road or new school construction, while corporations issue bonds to raise revenue needed for mergers and acquisitions. Bond terms normally last for at least six months, although national governments issue bonds lasting as long as 30 years. Long-term bonds pay lower rates of interest, but appeal to people looking for predictable payments over long periods of time. In the United States, income payments from municipal bonds are not taxable at the federal level, which makes the bonds especially attractive for investors in high tax brackets.
Common stocks are not thought of as fixed income instruments because the value of stocks fluctuates on a daily basis, and dividend payments are subject to change. Many large companies issue preferred stock, which does pay fixed dividends. Preferred stock dividends are normally taxable. To make the stocks an attractive investment, the dividend payments on preferred stocks are usually higher than the yields paid on bonds.
Investors who buy fixed income instruments are exposed to a variety of different risks, including insolvency risk, as a government or corporate bond issuer can only continue to make regular income payments while it remains solvent. If a bond issuing entity files bankruptcy, bond payments usually cease. Many bond holders eventually receive a portion of their investment back, but the loss of income can be problematic. When a corporation goes bankrupt preferred stockholders can claim a share of the failed firm's assets, but only after the taxes, payroll, and debts have been settled. Preferred stocks often becomes worthless after a company becomes insolvent, and many investors lose both an income source and their original investment.
People who heavily rely on fixed income instruments also have to contend with inflation risk. Prices tend to rise over time, which makes the cost of living increase steadily over extended periods of time. Fixed income payments remain unchanged, which means inflation erodes the spending power of investors. Some investors prefer to buy investments that offer variable rates, such as variable rate certificates of deposit, but while these investments do not expose people to inflation risk, investors cannot predict income payments from one month to the next.