Explaining Fixed-Rate Bonds

Fixed-rate bonds can provide a steady, secure stream of income and help protect your initial investment dollars, but it is important to understand that they are not without risk. Over the long haul, it is possible to lose financial footing with fixed-income bonds due to market risks and other factors.

Fixed-Rate Bond Information

Bonds generally are considered less risky than stocks because issuers—usually corporations, banks, or government entities—agree to pay investors a fixed rate of interest plus the amount of the initial investment at a later date. Therefore, when you purchase a bond, you are loaning money to a corporation or entity for a set period of time, or until the bond's maturity date. Companies and government entities issue bonds to fund a variety of business activities, including the purchase of equipment and property, mergers, acquisitions, and other expenses.

There are many different kinds of bonds, but those with fixed interest rates (as opposed to those with variable or floating rates) provide investors with the security of knowing in advance how much they will receive for their initial investment. In many cases, investors receive interest payments from the bond issuer at specified intervals before the bond matures. For example, someone who purchases a 10-year corporate bond for $1,000 and pays 5 percent interest would receive a total of $50 in interest payments each year for the life of the investment.

Fixed Rate Bonds vs. Other Types of Investments

While fixed-rate bonds tend to offer more security than stocks, overall returns often are lower. So, before buying a fixed-rate bond, it is important to first evaluate your long-term investment goals. Different types of bonds offer different advantages. For example, if you are looking for current income, you probably will want to consider bonds that provide regular fixed interest rate payments for the duration of the investment. On the other hand, if you have a goal that requires you to accumulate more money over a period of time (e.g. saving for retirement), you might want to consider purchasing zero coupon bonds. These debt securities are purchased at a discount from their face value, and, when they mature, you receive one payment equaling the purchase price plus interest compounded semiannually at the original interest rate.

Risk Types

While fixed-rate bonds offer several benefits and greater security than other investments, it also is helpful to consider some of the risks before deciding whether to invest in them. With fixed-rate bonds, there are risks associated with interest rates, default, inflation, and other factors.

Interest rates. The most common risk associated with bonds has to do with interest rates. By buying a fixed-rate bond, you are agreeing to receive a specific rate of return over a period of time. However, if the market interest rate increases after you purchase a bond, the value of your investment will fall accordingly. In other words, bond prices generally fall when interest rates increase. When this happens, bonds often are traded at a discount to reflect the lower return that an investor is likely to receive from the bond.

Inflation. The rate of price increases if the overall economy lowers returns associated with bonds—this is especially true when it comes to fixed-rate bonds. For example, if you purchase a bond with a 7 percent interest rate, but inflation increases to 11 percent after you buy the bond, you no longer have the same purchasing power with the proceeds from your investment. By contrast, bonds with floating rates are adjusted periodically to match inflation to limit risks to investors.

Call risk. A call risk refers to the possibility that a bond issuer will “call” or repurchase your investment earlier than scheduled. In other words, issuers sometimes purchase bonds back from investors and retire them. This often occurs when interest rates decrease significantly after bonds are issued. By buying back bonds, the issuer can then retire those with higher rates and sell ones with lower rates to help reduce the cost of their debt.

Default. It is possible to lose some or all of your investment as a bondholder if the company or entity that issued your bond goes bankrupt or is unable to pay the interest or principal on the bond on a promised schedule. Rating services such as Standard & Poor's provide investors with information that helps them evaluate how risky it is to purchase bonds from certain companies or entities. The ratings tell you how confident the rating agency is when it comes to the bond issuer's ability to pay scheduled interest and principal in a timely manner. A credit rating of “AAA” is the highest designation, whereas a rating of “BB” or lower indicates that an organization is more likely to default on its bond payments. Bonds that carry a higher risk of default—generally those with “BB” ratings or less—generally offer higher yields to entice investors.