Fixed income funds are considered by most investors as safe or conservative options compared to equity investments. However, under certain circumstances, they can also lose money, leaving investors with an unforeseen situation to deal with.
We will now explain the nature of fixed income funds and their role in the financial markets, as well as highlighting their perceived lower risk. A lower risk, that can often be misleading.
What are fixed-income mutual funds?
Fixed income funds are an investment category that can be simply described as “baskets” of debt issued by entities such as governments, municipalities, or corporations.
Instead of buying shares of a company (as is done in equity funds), when you invest in a fixed income fund, you are buying a collection of bonds or debt, acting as a creditor of the issuer of those debt securities, rather than as an owner.
These funds are generally considered safer and more conservative for several reasons:
- Predictable payments: Bonds in a fixed-income fund generally pay interest at a regular rate, providing a predictable income stream.
- Lower volatility: Compared to stocks, bonds tend to have fewer sharp fluctuations in value. This makes them less volatile and therefore safer.
- Principal protection: Fixed-income funds are frequently considered to have a lower risk of loss of invested principal, especially if held to maturity of the bond.
Can you lose money on fixed income?
Although fixed income funds are mainly considered safer or more conservative investments compared to equity funds, there is still the possibility of losing money. This can be due to several types of risks associated with these funds:
- Credit risk, which refers to the possibility that the bond issuer may not be able to meet its payment obligations, either interest or principal. If a company or government experiences financial difficulties, it could default on its bonds, affecting the value of the fund.
- Interest rate risk: Interest rate risk arises due to changes in market interest rates. If interest rates increase, the value of existing bonds tends to decrease, as new bonds are issued at higher rates, making them more attractive by comparison. This may decrease the value of the fixed income fund.
- Liquidity risk, which relates to the ease with which the fund’s bonds can be sold. In some cases, it may be difficult to sell a bond quickly without having to reduce its price, which negatively impacts the value of the fund.
In addition, macroeconomic events such as inflation, economic growth or political stability are examples of economic conditions that can influence the value of bonds and, consequently, the performance of a fixed income fund.
How to minimize risk when investing in fixed income?
To minimize risks when investing in fixed income funds, it is essential to adopt intelligent and well-informed strategies. Among these strategies are:
- Diversification: One of the most effective ways to reduce risk in any type of investment is diversification, and fixed income is no exception. This means not investing all of your capital in one type of bond or in bonds of one issuer. Diversification can be achieved by investing in a variety of bonds with different maturities, credit qualities and issuers, including governments and corporations from different sectors and geographic regions. This helps mitigate risk, as the negative performance of one bond can be offset by the positive performance of another.
- Analyzing the credit quality of issuers: before investing in a fixed income fund, it is important to analyze the creditworthiness of the issuers of the bonds included in the fund. Bonds issued by entities with high credit ratings tend to have a lower risk of default. Credit ratings provided by agencies such as Moody’s, S&P and Fitch can be a useful reference for assessing the credit quality of issuers.
- Time horizon consideration: Your investment horizon, or how long you plan to hold your investment, also plays a crucial role. Bond funds with maturities that match your investment horizon can help reduce interest rate risk. If your investment horizon is long, you may have the ability to hold a bond until maturity, which can minimize the impact of interest rate risk.
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