Fixed-income securities are a crucial part of any well-balanced investment portfolio. These are assets like bonds and Treasury notes that result in an all-but-guaranteed return, whether it be in the form of interest payments or discounts to face value.
At the same time, these securities are a great way to preserve value, which is important in case the market takes a turn for the worse. As safe havens, these investments are known to offset stock market volatility, often generating positive returns during times of economic and market struggles.
As you begin adding bonds and other fixed-income instruments to your portfolio, you’ll realize that time seems to play a major role in the returns you can expect to achieve. But why does the time horizon of the investment play such a crucial role in the return rate you can expect?
What Are Maturity Dates?
Fixed-income investments such as bonds are called debt instruments because that’s exactly what they are — they’re loans provided to the issuer in exchange for a fee, whether a coupon rate or a discount to the value of the security.
Just like any other loan, the original lender is only comfortable being without their money for a prespecified period of time.
Think of it like a mortgage, a car loan, or any other loan provided to consumers from banks. If you take out a mortgage, you’ll generally have the option to choose between a 15-year or 30-year loan.
If you buy a car on credit, you’ll have somewhere between three and seven years to pay it off in most cases. Regardless of what the loan is for, you’ll be required to repay that loan in a reasonable amount of time.
Maturity dates are essentially due dates on the loans investors provide to local, state, and federal governments or corporations by way of bonds and other debt instruments. Maturity dates spell out the period of time in which investors expect to be repaid.
Pro tip: Have you considered hiring a financial advisor but don’t want to pay the high fees? Enter Vanguard Personal Advisor Services. When you sign up, you’ll work closely with an advisor to create a custom investment plan that can help you meet your financial goals. Learn more about Vanguard Personal Advisor Services.
How Investors Earn Money with Fixed-Income Securities
Before you can truly understand how important a time horizon is in a fixed-income investment, it’s important to understand just what these investments are and how they’re used as a vehicle to generate profits.
There are two ways investors in these safe-haven assets earn a return:
Coupon rates, which are the income investor’s equivalent to interest rates, are paid by the security issuer — the borrower the investor is lending money to.
For example, if your coupon rate is 8% on a $1,000 investment, you earn $80 per year.
For most debt instruments, coupon payments are made twice per year, meaning that your annual return of $80 would be split into two payments of $40 paid to you every six months.
Discount to Par Value
The par value of a debt instrument is its face value upon maturity.
When bonds mature, the issuer repays the holder the full face value of the investment. Some debt instruments like zero-coupon bonds and Treasury notes offer a discount to face value upon the purchase of the asset.
For example, an investor may pay $950 for a $1,000 par value Treasury note with a maturity of one year. When the year is up, the investor receives the full value of the note — in this example, $1,000, making a $50 profit.
How Maturity Dates Affect Fixed-Income Investments
With debt instruments, investors lend money to corporations or governments, tying that money up for anywhere from several weeks to a few decades.
While it’s tied up in the investment, that money is useless to the investor — it can’t be used for anything else until the debt is repaid.
Of course, when you lend money, the amount of time should be factored into the returns the loan provides, and that’s exactly what fixed-income instruments do.
Longer-term loans come with higher interest rates than short-term loans. Similarly, investors expect higher yields when lending money to governments and corporations for a longer period of time.
Ultimately, all investors in debt — be they consumer banks or retail investors — need the promise of more significant returns as the time horizon associated with the debt lengthens.
Why Length of Investment Affects Returns
The big question for many beginner investors is why the term of the investment has anything to do with the annual return it will generate. It all boils down to two key factors, interest rate risk and reinvestment risk.
The interest rate environment at the time you purchase a fixed-income asset makes a huge difference in the returns the asset will provide. It all starts with the United States Federal Reserve, or Fed, a private institution charged by the U.S. government to oversee monetary policy.
Along with other changes to monetary policy, the Fed increases or decreases the federal funds rate to help maintain balance in the U.S. economy.
The federal funds rate is the interest rate financial institutions charge each other to lend money overnight on an uncollateralized basis. Interest rates on all sorts of loans move in the same direction whenever the federal funds rate changes.
For bondholders, a higher federal funds rate equates to higher yields offered on new investments.
This creates a problem for existing investors known as interest rate risk. If interest rates rise, new bonds will offer increased returns, making a bond purchased at a lower interest rate less attractive by comparison.
If you have your money tied up for a long time in a lower-yielding bond, you won’t be able to take advantage of the new higher rates. So, when interest rates rise, these investors experience an opportunity cost, or a loss due to the fact that their money could have generated larger returns elsewhere.
Investors know if they purchase a debt instrument in a low-interest-rate environment, there’s a strong chance that the rate will increase in the future.
In order to get investors to accept the risk of having their money tied up when interest rates eventually rise, issuers pay higher coupons on long-term bonds. The longer the maturity, the higher the return in most cases.
Nonetheless, the fluctuations in rates and returns work both ways. If a bond is purchased in a high-rate environment and interest rates fall, the value of the investment will increase on the secondary market.
That’s because there won’t be any new bonds available with the same maturity that pay as high an income as an existing bond purchased in the high-rate environment.
As an investor, it’s important to consider the implications of maturity dates based on your financial goals.
For example, a retiree would likely want to invest in long-term maturity dates because they pay the highest levels of income, while a younger investor may prefer to invest in shorter-maturity securities, giving them the option to pull out of the investment and take advantage of better opportunities in the short and medium terms.
Other Factors That Affect Returns
Bond investors know that there’s more than one factor to pay attention to when investing in debt instruments. Aside from the term of the investment, there are seven key factors that are taken into account when pricing these investments.
1. The Type of Security
First and foremost, not all fixed-income assets are created equal, and the type of security you purchase will play a major role in the returns you can expect to achieve. Some of the most popular types of bonds include:
Among the highest-risk debt instruments on the bond market are junk bonds.
These are bonds issued by corporations that have had difficulties paying their debts in the past, meaning that there’s a higher likelihood of default. As a result, the credit rating for these bonds is below that of investment-grade bonds.
Junk bonds are also known as high-yield bonds because they come with the highest returns in order to entice investors to accept the increased level of risk.
Corporate bonds are investment-grade bonds issued by corporations for a wide variety of reasons, and they will come with varying levels of returns based on many of the factors listed below.
Municipal bonds are issued by local or state governments that may need funding to complete public projects or balance cash flows in their books.
Because they are issued by governments, which tend to be stable, there’s a high likelihood that the debts will mature and be paid back successfully.
As a result, these bonds come with lower returns than those mentioned above.
Treasury bonds, often referred to as U.S. government bonds, are issued by the U.S. Treasury and are backed by the full faith and security of the United States government.
Because these bonds are backed by the strongest government in the world, they come with significantly lower risk than any other type of bond, resulting in a lower return on investment.
Finally, Treasury bills are short-term, zero-coupon bonds issued by the U.S. Treasury. These bills range in maturity from a few weeks up to one year.
Rather than paying an interest rate, they are sold at a market price slightly below face value and generate a profit for investors when they mature.
Because these investments are issued by the U.S. government and carry a short-term maturity, they tend to offer the lowest returns compared to the other options above.
2. Credit Risk
Regardless of the type of loan, creditworthiness will always play a role in the rates offered.
After all, loans given to consumers or entities with poor credit ratings have a high risk of default, whereas repayment is more likely on loans given to entities with higher credit quality.
As a result, bondholders pay very close attention to the credit of the bond issuer to ensure that they’ll be paid back or, if they take on risky debt, they’re being paid to accept that risk.
In the world of bonds, there are two highly trusted rating agencies that grade debt instruments according to their credit risk: Moody’s and Standard & Poor’s. Here’s how their rating systems compare:
|Moody’s||Standard & Poor’s|
|Below Investment-Grade||Below Investment-Grade|
3. Market Conditions
Whether you’re investing in stocks or fixed-income assets, market conditions will always play a role in what you can expect to see from your investments.
Here’s how the condition of the stock market leads to changes in the returns you can expect to see from bonds:
Bonds and other fixed-income assets are known as safe havens because they act as great stores of value when the market falters.
As a result, during bear markets when prices in the market are falling, investors tend to sell stocks and look to income assets as a way to keep their portfolios stable.
This leads to an influx of debt-instrument buying and an environment in which issuers don’t have to pay high returns to attract investors.
During bull markets, the largest opportunities are found on Wall Street, as stock prices across the board are more likely to experience upward movement.
During these times, investors look to sell their safer assets and use their investing dollars to tap into the high returns the equities market is offering.
At these times, bond issuers must offer increased returns to attract investors.
4. Tax Implications
When you earn money, you’re taxed on every dollar of income you bring in. Well, investing is another way to make money, and Uncle Sam doesn’t discriminate. If the money is made in the United States, he wants his piece.
However, different investments are taxed in different ways.
Returns from stocks held for less than one year are taxed at the standard income tax rate, while returns from stocks held for more than one year are taxed at the capital gains tax rate, which is significantly lower.
Returns from income investments are generally taxed at the standard income tax rate — that is, unless you invest in tax-exempt investments. Here’s the breakdown:
Standard Income Tax Rate
Federal, state, and local governments generally tax returns from corporate bonds as though they were standard income.
Your returns on corporate bonds will be taxed at your normal income tax rate, which can be as high as 37% for the highest-income earners.
Municipal bond returns are exempt from federal and state income taxes as long as they are purchased within the municipality you reside.
Otherwise, these investments will enjoy federal tax exemption but returns will likely still be charged state income tax.
Treasury note and Treasury bond returns are exempt from state and local taxes, but will still be charged federal taxes at the federal income tax rate.
5. Capital Structure
The capital structure of a company or government that issues a bond is often overlooked, but it’s a crucial factor when it comes to the bond’s pricing.
A capital structure is a roadmap of how the company will pay back its debts should something go wrong.
It’s a hierarchy of sorts that defines who gets paid first in case liquidation takes place, with some debt holders having priority — and thus the highest probability of recouping their investment — and those lowest in the pecking order getting whatever is left over.
For example, common stockholders are some of the last parties to be paid in the event of a liquidation. Next up comes preferred stockholders, then bondholders, with different classes of bonds ranking higher or lower on the priority list.
The most secured debts are paid back first, with unsecured debts generally being the last to be paid before compensating preferred shareholders.
The security of the debt and how high it ranks on the company’s capital structure helps to determine the reward investors can expect when they purchase it.
The higher up the cap structure the bond ranks, the safer it is and the lower the return on the investment will be.
6. Liquidity Risk
In the world of investing, the term liquidity relates to how quickly an investor is able to exit their investment by selling it and turning it back into cash.
Liquidity is important for two key reasons:
- Opportunity Cost. Investors like to have the ability to exit an investment they’re currently in to take advantage if a better investment opportunity comes along. If you can’t exit your investment, the difference between the returns you make and what you could have made becomes a cost known as opportunity cost. The more liquid your investment is, the easier you’ll find it to swap out for a better opportunity if one comes along, reducing your risk of experiencing an opportunity cost.
- Emergencies. Although most investors have an emergency fund that’s not tied up in the market, some emergencies can break the bank. It’s nice to know that you could fall back on your investments if you had to, but tapping into your investments in a dire emergency becomes less possible when liquidity is lacking.
Assets issued by companies and governments with high credit ratings that offer great returns are generally the most liquid fixed-income vehicles.
Before buying an income asset, take a moment to review the secondary market, paying attention to the trading volume associated with the bond. The higher the trading volume, the better its liquidity, which plays a significant role in returns.
7. Inflation Risk
Finally, inflation risk relates to the danger of inflation climbing at a faster rate than the money tied up in a fixed-income asset is growing.
Since 2008, inflation rates have been as high as 3.14% and as low as 0.12% per year, according to Statista. That means that when inflation rates were above 3%, investors who owned bonds paying a coupon of less than 3% were actually losing money.
Sure, they continued to receive their payments and got their principal investment back upon maturity. However, by the time they got their returns, the value of the currency itself had dropped so much that their money would buy less than it would have before.
When pricing bonds, issuers take the state of the U.S. economy and inflation rates into account. Nobody wants to buy a bond that doesn’t provide a positive return after inflation is factored in.
Any balanced portfolio has fixed-income securities somewhere within it.
These securities help to provide stability in an otherwise volatile market, offering a level of safety to investing that becomes increasingly important as investors near retirement.
Not only do these investments bring stability to an investment portfolio, they provide income that can be reinvested to increase your wealth or spent as ordinary income.
While maturity dates play a crucial role in the values and returns of these investments, so too do various other factors. That’s why it’s crucial that investors do their research before diving into any investing opportunity.
Pay attention to maturity dates and the prevailing interest rates as you research fixed-income investments to add to your portfolio.