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What’s the Difference Between Fixed Income and Bond Funds?

Investors tend to lump fixed income and bonds into the same group. But that is not always the case. Fixed income is defined as any investment in which the issuer is obligated to make fixed payments on a fixed schedule. Investors who purchase fixed income securities are typically looking for higher yields and less volatility than equities. There are a multitude of various securities that can be considered fixed income, outside of just bonds, which investors traditionally equate with all fixed income.

This article will discuss some of the differences between fixed income and bonds.

Bonds and Other Fixed Income Securities

When a corporation wants to raise financing, it can do so by either issuing debt or equity. When it issues debt in the form of bonds, it borrows money from a lender, and in return, makes a contractual agreement to repay the principal as well as interest over the course of the loan. There are many bond mutual funds that investors can choose from. For example, the Vanguard Total Bond Market Index Fund (VBTLX) holds more than 5,000 domestic investment-grade bonds. It invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities.

However, there are many other types of fixed income securities. For example, sometimes companies will issue preferred shares. These securities are a hybrid of bonds and equities, in that they receive distributions before equity holders but after bondholders. Preferred stocks carry ownership rights like equities, but typically do not offer voting rights. A preferred stock fund that investors can purchase is the Nuveen Preferred Securities Fund (NPSAX).

Alternatively, there are other fixed income securities available. Some mutual funds contain mortgage-backed securities or bank loans. Examples of these include the Fidelity Mortgage Securities Fund (FMSFX) or the Fidelity Floating Rate High Income Fund (FFRHX). The FMSFX fund invests at least 80% of assets in investment-grade mortgage-related securities. This fund currently yields 2.1%. Meanwhile, the FFRHX fund invests at least 80% of assets in floating rate loans, which are often lower-quality debt securities, and other floating rate debt securities.

Consider the Risks Before Investing

Most fixed income securities have interest rate risk in common. That is, the risk of rising interest rates, which are generally perceived as detrimental to fixed income securities. As interest rates rise, investors require higher yields to compensate. Since fixed income prices and yields are inversely related, higher interest rates typically result in lower prices.

Another risk to be aware of is default risk. Default risk is the risk of an issuer defaulting on its contractual agreement, and failing to repay principal. Different fixed income securities carry varying levels of default risk. Higher-investment grade corporate bonds, such as those with ‘AAA’ credit ratings, tend to have very low default risk. On the other hand, floating rate loans tend to be lower-quality bonds with higher default risk. Ultimately, investors should determine their own particular needs and risk tolerances before investing.

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Oct 06, 2015