Bonds are fixed income investments. Image: U.S. Treasury.
In most investors' eyes, the stock market gets all the attention. Given how the right stocks can multiply your money many times over, the relative calm of fixed income investments seems boring by comparison. Yet for smart investors who use asset allocation strategies to ensure they have the short-term liquidity they need, making the most of the fixed income market is a key component of your overall investing plan. Let's look at the challenges of fixed income investing with an eye toward helping you earn more from this part of your portfolio.
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Why you need fixed incomeOver the past several years, many investors have given up on fixed income entirely. The plunge in interest rates has led to unprecedented low levels of income from many once-popular fixed income options, including bonds and bank savings and CD accounts. Options that at one time paid 5% to 6% annually now pay just a tenth that much, and even long-term Treasury bonds with maturities of 10 years pay barely 2% -- essentially just keeping pace with the rate of inflation. By contrast, many dividend-paying stocks offer higher dividend yields than that, and the prospect of growth potential makes stocks even more attractive to many.
The problem with using only the stock market, though, is that you leave yourself vulnerable to market downturns at a time when you might need cash for spending. Ideally, you should have a five-year time horizon for your stock investments in order to ensure that you won't have to panic-sell after a market drop in order to generate needed cash. For expenses you anticipate sooner than that, looking at fixed income options can take away much or all of the market risk and leave you with greater certainty of not losing principal -- even if it comes at the expense of less income along the way.
How to make more from fixed incomeIn a low-rate environment, fixed income investing can be frustrating. But there are some things you can do to squeeze more income from your portfolio even when rates are low.
First, don't hesitate to shop around for the best rates available. Many major banks offer interest rates as low as 0.01% on their savings accounts, citing the Fed Funds rate in the range of 0% to 0.25% as evidence that such a low rate is appropriate. Yet if you turn to online savings account options, you can find banks paying as much as 1% or even slightly more, even though these accounts are fully insured by the FDIC and have many of the same features that bigger banks offer. Similarly, it's not uncommon to find disparities of a percentage point or more on CD rates depending on how long the maturity is and whether you can find locally based financial institutions willing to offer you an even better deal.
Second, when you set up your fixed income portfolio, consider using a laddering strategy to take advantage of the higher rates on longer-maturity investments. For example, instead of putting all your money in a three-month CD and accepting a top rate of around 0.5% right now, considering putting a portion in that CD and using longer-term CDs ranging from six months and one year up to five years. The longer the maturity, the higher the rate usually is, and the right balance between liquidity needs and income can help your fixed income strategy be more successful.
Finally, be aware of the risks in the fixed income market. Many investors mistakenly think that there's no risk to fixed income, but changing interest rates, differing credit quality, and the ebb and flow of the business and economic cycles all play a part in determining the behavior of the fixed income market. In particular, you should always be suspicious of investments offering rates that look too good to be true, because often, you'll find that they are -- at least in the long run.
It's easy to think that fixed income investing is irrelevant compared to the huge gains that are possible in the stock market. Yet from a money management perspective, making the most of fixed income is an essential part of a successful all-around financial plan. Take the time to understand fixed income, and you'll have a much better job of generating the income you need to enjoy the standard of living you want throughout your lifetime.
The article Why Fixed Income Investing Is More Important Than You Think originally appeared on Fool.com.
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