Acquiring investments that provide some type of fixed income or return is often considered a great way for more conservative investors to incrementally build viable investment portfolios. While this approach does offer the benefit of carrying a low amount of risk, there are also fixed income risks that investors should consider before relying too strongly on these conservative assets that provide fixed income returns. Among the risks that should be considered are shifts in the average interest rates, the economic impact of a recession or a period of inflation on the returns from a fixed income investment, and the potential that the investment will be called early by the issuer.
One of the more common fixed income risks has to do with shifts in the average interest rates that currently prevail in a given market. Since the amount of return that is generated from the asset is tied to the fixed rate itself, the investor may actually be losing money if the economy moves in certain directions. For example, if the average interest rate in the housing market slumps well below the fixed rate a property owner locked in on a mortgage several years ago, the owner is actually incurring a greater expense with the debt obligation, which in turn limits his or her return from renting the property. Depending on how volatile the market is, the investor may find it more advantageous to move from the fixed rate to a floating or variable rate that responds to whatever is happening in that market.
In fact, investors may find that there are fixed income risks in a number of markets, based on what is happening in the wider economy. A fixed rate that is considered highly profitable today may be less attractive when the economy moves in a given direction for an extended period of time. While the investor may still earn some type of return, that amount is much less than if he or she had been willing to assume additional risk and go with a floating rate. This is true for not only real estate, but also futures contracts involving different commodities or bond issues.
Along with the fixed income risks connected with a shifting economy, there is also the potential that the issuer will call the holding before it reaches maturity. When this happens, the investor will not realize the amount of return he or she originally projected. For example, if a five-year bond issue was structured to pay 5% interest at the date of maturity, but the issuer calls the bond at the three-year mark, the adjusted return will be considerably less. If the bond had been configured with a floating rate and the economy had moved in a certain direction, that return may have been greater, even with the early call.
While going with investments that carry a fixed rate is a sound approach, it is important to diversify the portfolio to include other investments that carry a higher level of volatility. Doing so makes it possible to always have a solid cushion that is highly unlikely to be undermined, even if some investments are called early. In addition, the diversification also means that losses in one quarter are offset with gains in others, a combination that is likely to allow the investor to move forward in spite of any fixed income risks that may be associated with a portion of the holdings within the portfolio.
