In the last part, we talked about equities — one of the major investing instrument classes. Today we’ll be talking about equities’ less risky cousin, fixed income.
I suppose we should start off with why fixed income is, on average, less risky than equities in the first place. Well remember when I said equities represent ownership in the firm, and that’s where the added risk comes from? Fixed income works the opposite way — instead, you’re the loaner to the firm.
Much like how the banks take less risk loaning out money to the entrepreneur, fixed income investors take less risk giving their money out to the fundraiser. This is because of the rules set in place that nearly guarantee a fixed income investor will make their money back — from regular interest payments to first dibs on a company’s assets when they go bankrupt.
There are a few different ways to invest in fixed income. The first, more direct way is to finance debt (for our purposes, “fixed income” is analogous to “debt” in the same way that “equities” were analogous to “stocks”). This method is more complicated, but entitles you to the aforementioned interest payments and bankruptcy assets. It’s also worth noting that, like equities, buying directly is a lot more expensive and a lot harder to diversify.
So if you want to focus on diversification, your second option is — you guessed it — funds! Mutual funds and ETFs exist the same way they do for equities. However, since funds and ETFs trade as equities, you’re only getting the lower risk power of fixed income in this case — the interest never reaches you, and while a single bankruptcy won’t affect your fund, you won’t see any assets out of it.
One last note here: fixed income has an additional risk differential based on who you’re loaning out to. Within debt, you aren’t just able to give money to companies now — you’re able to give it to countries as well. This debt is called sovereign debt, and is much less risky than corporate debt. Think about it: what’s more likely to go under, a single business or an entire nation state?
That’s really all I wanted to talk about in terms of fixed income investing. Our last part, coming next week, will detail some indicators and things to look out for, in individual firms and for the economy as a whole.