I’m really excited to share with you a post from Akash Sky from akashsky.com. He is extremely knowledgeable about investments and goes in depth on a lot of complex topics which I appreciate, and I think you will too. Enjoy his post on Fixed Income, I think it will be valuable to new and seasoned investors. I hope you enjoy it, if you’re looking for more: I wrote a post for his site about Investing in Yourself. When you’re finished, check it out here. Enjoy Akash’s post:
Fixed income is a special type of investment – one that I’m particularly fond of. Basically, its an investment that pays you a fixed amount of money over a specified period of time. Every month, you can count on a steady pay check from a fixed income asset, much like a paycheck from a job (without the work). Let’s talk a bit about the pros and cons of fixed income investing before moving on.
The most attractive feature of fixed income is that the income is fixed. Essentially, you can count on getting that exact income each and every month. This differs vastly from other equities like stocks in that the amount of money you receive each month varies wildly (if the stocks pay you at all)!
In addition fixed income investments carry less risk than their equity counterparts. So, to summarize, fixed income is good for the following reasons:
- Steady, reliable income
- Lower risk compared to other equities
However, fixed income has its share of cons. The first con is that fixed income assets generally have weak appreciation. This means that fixed income assets generally do not increase in value over time as much as other equities like stocks. You can buy a stock, hold it for a few decades, and easily sell it for much more than you initially paid. For fixed income assets, this is much harder to pull off.
Secondly, fixed income assets typically don’t keep up with inflation. Every year, the costs of goods and services rise due to inflation (the gasoline you put in your car cost a few cents more per gallon, your grocery bill rises year over year, etc.). However, fixed income assets pay out the same amount each month regardless of inflation. As a result, you slowly lose purchasing power over time.
So, to summarize:
- Weak appreciation potential
- Loses to inflation
Now that we have a brief overview of the pros and cons of fixed income, lets talk about 5 awesome fixed income investments you can make.
1. CDs and Saving Accounts
Although you may not necessarily be aware of it, you are probably already a fixed income investor! Your savings account at your local bank is a perfect example of fixed income. You put your money in the bank and then the bank slowly pays you interest. Saving accounts are great because they are extremely liquid (you can take your money out whenever you want) and extremely safe (FDIC insured for at least $250K).
Certificates of Deposit
Certificates of Deposit (CDs), are a lot like saving accounts, with a special condition. When you open up a CD, you promise that you will leave your money at the bank for 1-5 years. In return, the bank will pay you a slightly higher interest rate than you would get with a regular savings account. CDs are great because they are safe and pay a slightly higher rate than a savings account. However, you have to be okay with locking up your money for a few years.
- Extremely Low risk
- Extremely low yield
- Interest income is taxed at your ordinary rate
I think that CDs and saving accounts are only good for holding emergency funds and should not be used to hold most of your cash because their returns are too low (in addition to being tax inefficient).
When was the last time you borrowed money to purchase something? Was it when you bought your house? Your car? Your education? Well, if you’ve borrowed money, I’m fairly certain you’ve had to make monthly payments on your loan. That is exactly what a bond is – except reversed. Instead of borrowing money, you are lending it and collecting interest in the form of monthly payments. Bonds come in all sorts of forms and varieties. Some of the most common are Municipal, Corporate, and US Treasury bonds.
Whenever your city wants to start a large project, (like construction of roads, building a bridge, etc.) chances are that they don’t have millions in a bank account to fully finance the project. In order to finance the project, the city will probably take on debt in the form of municipal bonds. By purchasing a municipal bond, you help the city fund a project. What makes municipal bonds special is their tax treatment – they are immune to federal income taxes! They can also be immune to state income taxes if you purchase bonds from your home state.
- Low risk
- Tax advantaged earnings
- Returns can be low
Municipal bonds should only be bought if your tax rate is very high. This is because the main selling point for municipal bonds is that they are exempt from income taxes. As a result, the higher your tax rate is, the more attractive of an investment they become.
I’ve personally invested in a leveraged California municipal bond fund, NAC* (leveraged meaning the fund borrows money to purchase more bonds). I did so because my marginal tax rate at the time was 35.3%, which made the tax free income from NAC very appealing.
*Always invest in bonds through a bond fund, not individually! This increases your liquidity and reduces your risk.
Like cities, sometimes companies need to finance major projects or may simply need cash for some reason. In order to obtain cash, the company can issue corporate bonds to raise capital. These bonds vary widely in risk depending on the issuing corporation. However, they tend to pay higher yields than municipal and us bonds (since they carry higher risk).
- Higher yield
- Higher risk
- Taxed at ordinary rate
I came close to investing $1000 in a corporate bond paying 6.5% issued by Solar City (a solar panel company that was acquired by Tesla). I decided against purchasing it because I knew nothing about Solar City’s financials and whether or not it was a secure investment. Personally, I dislike investing in corporate bonds due to the risk/reward ratio not being satisfactory. I think that you take too much risk for low post-tax returns when buying corporate bonds.
US government bonds are used to fund government operations that tax revenue can’t cover. The US government is notorious for borrowing – the current national debt is nearly $20 trillion! The main reason people purchase US bonds is that they are considered one of the safest investments in the world.
- Extremely safe
- Low yields
- Taxed at ordinary rate
The only US bonds I’ve ever invested in are I-bonds, which I use to hold my emergency funds. You should only invest in US bonds if you are looking to preserve your capital because they are one of the “safest investments in the world”. The yield on these bonds is usually low so you won’t experience too much growth.
3. Preferred Stock
Preferred stocks are a hybrid asset class – they are a mix between stocks and bonds. To better understand how preferred shares work, we need to consider what a company does when it makes money. First the company pays off its bond holders, then pays preferred stock holders a dividend, reinvests whatever it needs to in the company and then pays out common stock holders a dividend if there is anything left.
Essentially, preferred shares are second tier “debt”, just behind the bond holders. Although preferred shares are much less safe than bonds, they are typically taxed at a much more favorable rate. However, preferred shares do have one critical shortcoming – they can be “called” by the issuing company. In order to understand what “calling” means, imagine that you borrowed $100 from your friend at 12% interest for 1 year. After paying your friend $1 a month for 6 months, you decide you are sick and tired of paying him interest. As a result, you simply pay him back the original $100 you borrowed. Companies can do the exact same thing with preferred stock, and when do, they “call” the stock and buy you out.
- High yield
- Favorable tax rate
- High risk
- Can be bought out if the company decides to call your stock
I absolutely love preferred stock due to the fact they give out consistent payments like bonds and are taxed favorably like stocks. Its like getting the best of both worlds! I’ve invested in preferred stock ETFs (exchange traded funds), and individual preferred stocks. If you want to get started in preferred stocks, I’d highly suggest looking into ETFs that invest in preferred stocks like PGX. Of course, if you want to chase higher returns, feel free to purchase individual stocks at your own peril.
4. Secured Debt
If you own a home with a mortgage or a financed car, you are already familiar with secured debt! Basically, secured debt involves a loan with something else as collateral in case the borrowing party fails to pay back the loan. This decreases risk for the lender because if the borrower defaults, the lender can take the collateral to recoup their investment. However, secured debt is not without its risks, as we saw in 2008-2009 mortgage crisis.
- Lower risk than unsecured debt (but still carries quite a bit risk when lending to individuals)
- Typically lower yields (compared to unsecured debt, but the yields can still be very high)
- Taxed at ordinary income rate
I’ve just started investing a few thousand dollars via RealtyShares in home renovation loans (basically loans to people who want to fix and flip houses). As a result, I haven’t yet had enough time to form an opinion. At first glance, it seems relatively safe given that investment is backed by real estate. However, looks can be deceiving. RealtyShares requires that you be an accredited investor (net worth of 1 million dollars or 200K annual income) to invest, but does not actually confirm whether or not you actually are. As a result, you could technically lie and invest as an unaccredited investor – not that I would suggest you do such a thing!
5. Unsecured Debt
Every time you use your credit card, the credit card company gives you an unsecured loan. Essentially, should you decide to default on your credit card (not recommended!) the credit card company is out luck since the loan wasn’t backed by anything (however, the credit card companies more than make up for it by charging excessively high interest rates). Fortunately, you too, can be like the credit card company and loan out money at high interest rates.
- Very high yields
- Very high risk
- Taxed at ordinary rate
- Low liquidity
LendingClub and Prosper are the two leaders in Peer 2 Peer lending marketplace and allow you to invest in unsecured debt. I’ve personally invested $5500 in LendingClub via a Roth IRA. My strategy involved investing in high risk, high reward notes in order to hopefully get a high return. Unfortunately, many of my notes have began to default leaving me a pitiful 6% return as of right now (I was hoping for 10% given the amount of risk I am taking). If you do want to invest in peer 2 peer lending, I strongly suggest you do so through a Roth / Traditional IRA in order to pay less taxes. I also suggest that you avoid extremely risky notes.
How to Decide Which Fixed Income Investment is Best for You?
We’ve covered a lot of different fixed income opportunities for you to start investing in. However, which one should you go for? Luckily, I’ve made a flow map info-graphic that’ll help you find the best fixed income investment suited for your needs. All you need to do is answer some yes / no questions and follow the appropriate path! Put your name and email below and I’ll direct you to it instantly.