Understanding the dangers of fixed income is crucial for individuals looking for stability and safety in their investments.
Many individuals tend to overlook or underestimate the risks associated with this type of investment, which can directly affect earnings and even lead to a loss of invested funds.
This article discusses the primary dangers associated with fixed income investments and ways to reduce them for improved decision-making in this investment sector.
What does fixed income refer to?
It is crucial to comprehend the nature of fixed income investments before exploring their associated risks.
Fixed income involves providing funds to a financial entity like a bank or government in return for a set payment.
The compensation could be predetermined when applying or linked to a specific index like the Selic rate or inflation.
To learn more about INCO’s fixed income and collective investments, we have prepared this video for you.
Understanding the principles of fixed income investments
In this kind of investment, the investor loans money to a financial institution and receives a fixed return in exchange.
The compensation can be predetermined when applying or linked to a specific index like the Selic rate or inflation.
Public titles, such as those issued by the government to finance their activities and projects, can be bought and sold by individuals through the Direct Treasury, an online platform provided by the National Treasury.
Private securities like CDBs, LCIs, and LCAs are offered by financial institutions and businesses to raise capital from investors.
What is the return on investment for fixed income?
The returns from fixed income investments vary depending on the chosen application and may not always be fixed, despite the name. Two primary formats are used to calculate yields.
- The return rate is established when the investment is made, guaranteeing a predetermined and fixed percentage.
- Profitability is linked to a variable indicator like inflation or CDI, so the exact return percentage is uncertain until later on.
In the case of investments with post-fixed terms, there is no assurance of a fixed percentage.
Difference between fixed income and variable income – What distinguishes the two?
Fixed income and variable income differ primarily in their income rules. Fixed income sets the return conditions at the time of application, with investors aware of the deadline and method for calculating earnings.
In variable investments, outcomes are uncertain and there is a risk of losing some or all of the invested amount. Conversely, fixed investments offer lower risk of loss due to safeguards like the Credit Guarantee Fund (FGC) which provides protection up to a certain limit, even in the event of bank failure.
Variable income has the potential for greater returns if it performs well, but fixed income is a better choice when results are negative.
What are the most prevalent fixed income investments?
Treasure Hunt
The Direct Treasury is a popular choice among new investors as it enables individuals to buy public bonds online through a national treasury program.
Selic is a recommended option for new investors due to its daily liquidity and low risk, as it has specific characteristics and maturity deadlines.
Would you like to learn more? Watch this video that we have prepared for you.
Certificates of Deposit at Banks (CDBs)
Another choice for investing in fixed income is Bank Deposit Certificates (CDBs), where you lend money to a bank and earn interest in return.
There are various types of CDBs, including fixed and variable rate ones, each with its unique features and fixed income risks. Would you like to learn more? Check out this video we’ve prepared:
Real estate credit letters (LCI) and agribusiness credit letters (LCA)
LCIs and LCAs are investment choices in fixed income designed to raise funds for the real estate and agriculture sectors, with the added benefit of tax-exempt income.
Fixed income alternative investments
Alternative investments are financial assets that do not fit into the conventional categories.
INCO’s investment model is a form of alternative investment where individuals invest money in projects or companies in return for interest.
Fixed income risks
Fixed-income investments carry less risk than variable-income investments such as stocks, currency, or gold.
That being said, they are not entirely without risk.
Some risks of fixed income that require close attention.
Credit risk refers to the possibility of loss due to a borrower’s failure to repay a loan or meet their financial obligations.
One key concern for fixed-income investors is credit risk, which involves the issuer’s potential inability to make interest or principal payments.
Fixed income securities from companies with lower credit ratings or countries with a higher risk of default pose greater credit risk.
These issuers are seen as riskier by investors, leading to higher interest rates as a form of compensation.
Even in government bonds or those issued by companies with higher credit ratings, there is always a possibility of credit risk as any issuer may encounter unforeseen issues.
To reduce credit risk, diversify investments across various issuers and sectors while assessing the issuer’s credit quality before investing.
Liquidity risk
Fixed-income investors should also take into account the risk of liquidity, which refers to the ease of selling a security promptly without incurring substantial losses.
The liquidity risk happens when an investor is unable to sell a security when desired or during a period of low market liquidity, leading to financial losses.
Investors close to retirement or in need of emergency funds face a higher risk, particularly those requiring quick access to their money.
To reduce liquidity risk, you can invest in highly liquid fixed income securities like those traded on the stock exchange or with shorter maturity dates.
Reinvestment risk refers to the risk associated with reinvesting funds from an investment that has matured or been called before its maturity.
Fixed-income investors should also be cautious about the reinvestment risk, which occurs when they may struggle to find a new investment offering a similar interest rate or return upon the maturity of their current fixed income investment.
Consider investing in fixed-income securities with shorter maturity to reduce the risk, as this enables you to reinvest your funds over a shorter period.
Management or operational risk.
The risk is connected to the manager’s capacity to make optimal investment choices to increase the fund’s returns, and it can appear through various means like selecting poor investments, lacking portfolio diversification, or using inappropriate investment strategies.
Investors can reduce management risk by opting for investment funds led by seasoned and accomplished managers. Prior to investing, it is crucial to evaluate the fund’s past performance and investment approach.
Investing directly in fixed income securities instead of investment funds is another method to reduce management risk.
Identifying the market
The changes in the market value of fixed income securities can result in either profits or losses for investors, depending on when they choose to sell the assets.
Updating the value of a fixed income security daily to reflect current market conditions is known as marking the market.
The title’s value can change based on fluctuations in interest rates and other factors influencing its worth.
When interest rates go up, the value of fixed income securities tends to drop because new securities offer higher interest rates. This can have a significant impact on fixed-income investors, particularly in a rising interest rate environment.
Investors can reduce the impact of these effects by opting for longer-term fixed income securities to lower their vulnerability to short-term fluctuations.
Investing in fixed income securities – how to do it?
When investing in fixed income, the initial step is to grasp the available choices. Following this, identifying the asset type that matches your goals and risk tolerance is crucial.
An investor’s risk profile is crucial in determining whether they should opt for safer investments like government bonds or Certificates of Deposit (CDs), or if they can take on more risk with investments like corporate bonds.
It is important to assess the timeframe of the investment and the liquidity requirements, which refer to how easily you can access the invested funds if necessary.
maturity
Investments in fixed income can have different time frames, ranging from a few months to several years, which is another key aspect to consider.
The length of the maturity period impacts both the return on investment and the investor’s flexibility. For instance, long-term investments like the IPCA+ Treasury offer greater profitability over time but necessitate careful planning to avoid needing the funds before maturity.
Investors looking for liquidity may find options like Selic Treasury or CDBs with shorter maturities more suitable, as they enable early redemption with minimal yield impact.
Earning potential
Fixed income investments can have pre-determined, post-determined, or hybrid profitability structures. In pre-determined investments, the investor is aware of the exact amount they will receive at the end of the investment period.
This title is suitable for individuals looking for predictability. Fixed-income investments are linked to a specific index, like CDI or inflation (IPCA), so the return can fluctuate based on the performance of these indices.
Hybrid investments like the IPCA+ Treasury provide a mix of fixed returns and a linked adjustment index, such as IPCA, safeguarding investors against inflation.
Taxation
Taxation on fixed-income investments typically decreases over time, with lower income tax rates applied as the investment duration increases.
Shorter-term investments may come with higher rates, affecting the overall returns. Besides income tax, certain products like CDBs may also be subject to IOF, particularly for early withdrawals.
Some of the primary rates and taxes include:
Charge/ Tax | Explanation |
IOF | Targets profits from brief investments (up to 30 days). |
IR | Changes based on the duration of the investment, with a regressive nature. |
Custody Charge | Fee imposed by certain entities for holding the asset. |
How to report fixed income investments for income tax purposes
It is a legal obligation to declare fixed income investments on your income tax return to prevent issues with the tax authorities.
The process may appear difficult, but it is straightforward when done correctly. Follow each step carefully.
- Access the program of the Federal Revenue and select the “Assets and Rights” category.
- Choose the correct code for the type of fixed income investment you possess.
- Inform the institution from which you bought the titles.
- Enter the complete investment amount in the “Situation” field.
- Record all the earnings received during the year in the appropriate section.
- Repeat the process for every kind of application.
- Review all details carefully prior to finalizing the statement.
Using the income reports from financial institutions is crucial to verify the accuracy of the information.
Tips for effectively investing in fixed income
Opting for fixed income investments provides stability and predictability in returns. To enhance profits and reduce risks, it is advisable to heed the following two recommendations:
- Distribute your investments across various fixed income assets instead of concentrating on just one type.
- Stay informed about the charges and taxes associated. These can differ and have a direct effect on the ultimate return.
Always ensure to obtain trustworthy information about the financial organization you plan to invest in. A reputable institution typically entails reduced credit risks.
Liquidity levels
The ease of accessing funds before the investment reaches maturity should also be considered.
Certain products, like the Selic Treasury, provide strong liquidity, enabling withdrawal at any moment without significant losses.
Investments like debentures and long-term CDBs have limited liquidity, which may impede early access to funds.
Issuer’s stability
It’s important to also take into account the stability of the organization that issued the investment. The security of your investment often depends on the financial well-being of the issuing institution.
Before investing in a CDB or debenture, it is essential to assess the institution’s risk rating from agencies like Fitch, Moody’s, or Standard & Poor’s. This evaluation aids in comprehending the investment risk level and enables better decision-making.
The function of the Credit Guarantee Fund (FGC)
Investing in fixed income can provide a safe and predictable financial option, but there are risks involved, such as the issuer failing to make interest or principal payments.
The Credit Guarantee Fund (FGC) was established to offer extra security to investors in the event of default or insolvency of the issuer of fixed income securities.
What types of income risks are protected by FGC?
The fund provides protection of up to R$ 250,000.00 per individual taxpayer ID and per financial institution. This indicates that if the issuer of the fixed income investment you hold goes bankrupt and you have invested up to $250,000.00 in that institution, the FGC will ensure the recovery of that amount.
In conclusion
Investing in fixed income can be an appealing choice for individuals seeking a low-risk investment with predictable returns.
There are various risks related to this kind of investment that investors should know about, as mentioned in this article.
It is crucial to consistently keep track of your fixed income investments and be ready to modify your investment approach as necessary.
Comments