Defining Variable Income Securities
The term ‘variable-income security’ refers to investments that provide their owners with a rate of return that is dynamic and determined by market forces. Variable-income securities provide investors with both greater risks and greater rewards.
The most common examples of variable-income securities are stocks or shares. Their value depends on what the market thinks about the company, and they constantly change. When invested in stocks, you can’t be sure how much you will get in returns, or whether you will get anything at all.
Besides the market sentiment, fluctuations in interest rates also affect the income variable-income securities provide. Variable-income bonds, for example, may yield higher income when there’s a hike in interest rates.
In general, variable-income securities provide growth potential – but they are also unpredictable and riskier than fixed-income securities.
Variable vs Fixed-Income Securities – What Are the Differences?
The main difference lies in the predictability of return on investment.
Returns through variable-income securities are not guaranteed, and cannot be known from the get-go. Fixed-income securities provide the exact opposite:
They provide a constant stream of income and aim to pay the original investment eventually. The most common example of fixed-interest securities are bonds issued by corporations, municipalities, and governments.
An issuer issues a bond to raise money – meaning that when you purchase a bond, you effectively lend them the funds they need. In return for your money, you receive regular payments (called coupons) at set intervals. When a bond is issued, the issuer promises to pay the bondholder a fixed amount of interest, known as the coupon rate. Every bond has a maturity date. When a bond reaches maturity, the issuer pays the investor the total amount they paid to buy the bond originally (called the principal).
For example, if an investor purchases a bond with a face value of $1,000 and a coupon rate of 5%, the issuer will pay $50 in interest to the investor every year until the bond matures. When the bond reaches maturity, the issuer pays the $1,000 back to the investor.
The safety and reliability fixed-income securities offer make them a great option for conservative investors, or those who seek stable sources of income, such as retirees.
Potential Earnings Also Vary – Higher the Risk, Higher the Potential for Growth
The predictability also makes fixed-income securities quite rigid and limits the earning potential. They commonly have low returns, and slow price increases (or capital appreciation). Plus, they provide a fixed interest payment regardless of where market interest moves. If you purchase a bond paying 3% a year, you will lose income if interest rates rise above 5%.
This leaves fixed-income securities vulnerable to inflation. The rising cost of living may erode the return on fixed-interest securities if the inflation rate is higher than the fixed interest rate.
Variable-income securities, on the other hand, promise higher growth potential for those who are willing to tolerate greater fluctuations. The average return rate from stock investments ranges from 7% to 10%, whereas 15-year return from fixed-rate bonds hovers around 2% and 3%.
Ultimately, the right investment choice will depend on an individual's investment goals and risk tolerance.
Striking a Balance
One way to reap the benefits of both variable and fixed-income securities is to have a diversified portfolio mix containing both. This can provide a balance between the stability of fixed-income securities and the potential for higher returns with variable-income securities. For example, you could invest 60% of your portfolio in variable-income securities and 40% in fixed-income securities.
What Does a Diversified Portfolio Look Like?
Let's consider a hypothetical scenario to illustrate how a 60/40 portfolio might perform in different market conditions.
Suppose you have a starting portfolio value of $100,000, and you decide to invest 60% ($60,000) in variable-income securities (e.g. stocks) and 40% ($40,000) in fixed-income securities (e.g. corporate bonds).
Over the course of a year, let's say the stock market experiences a strong bull market and returns 20%, while the bond market remains relatively stable and returns 3%. In this scenario, your portfolio would have earned a weighted average return of 15.4%:
60% of the portfolio invested in stocks would have gained 20%, resulting in a return of 12% for this portion of the portfolio
40% of the portfolio invested in bonds would have gained 3%, resulting in a return of 1.2% for this portion of the portfolio
The weighted average return of the portfolio would be (0.6 0.20) + (0.4 0.03) = 0.154, or 15.4%.
So in this scenario, your portfolio would have increased in value to $115,400 (i.e. $100,000 * 1.154).
Now let's consider a different scenario, where the stock market experiences a significant downturn and loses 10% over the course of the year, while the bond market again remains relatively stable and returns 3%. In this case, your portfolio would have earned a weighted average return of -3.6%:
60% of the portfolio invested in stocks would have lost 10%, resulting in a return of -6% for this portion of the portfolio
40% of the portfolio invested in bonds would have gained 3%, resulting in a return of 1.2% for this portion of the portfolio
The weighted average return of the portfolio would be (0.6 -0.10) + (0.4 0.03) = -0.036, or -3.6%.
In this scenario, your portfolio would have decreased in value to $96,400 (i.e. $100,000 * 0.964).
If you didn't invest in fixed-income securities in the scenario described, your entire portfolio would have been invested in stocks. As the stock market experiences a 10% decline, your portfolio would have lost 10% of its value. Therefore, the value of your portfolio would have decreased from $100,000 to $90,000. This means that you would have lost $10,000 in this scenario instead of $3,600.
Of course, these are just hypothetical examples, and actual returns may vary depending on a wide range of factors, including market conditions, investment choices, fees and expenses, and more.
It's also important to consider diversifying within each category. For fixed-income securities, you could invest in a mix of government, corporate, and municipal bonds, as well as bonds with different credit ratings.
When a company or government wants to borrow money by issuing bonds, they are essentially asking investors to lend them money. To help investors assess the risk of lending money to the borrower, credit rating agencies evaluate the borrower's creditworthiness and assign them a credit rating.
Credit ratings are usually letter grades that indicate the likelihood of the borrower being able to pay back the bond's principal and interest on time. The higher the credit rating, the lower the risk of default, and the lower the interest rate the borrower will have to pay to attract investors.
For example, a bond with a AAA credit rating means that the borrower is considered very safe, and the likelihood of default is low. On the other hand, a bond with a C credit rating means that the borrower is considered risky, and the likelihood of default is high. As a result, the interest rate the borrower will have to pay to attract investors will be higher.
For variable-income securities, you could invest in a mix of stocks, mutual funds, and exchange-traded funds (ETFs) that track different sectors and regions.
Overall, diversifying with a mix of fixed-income and variable-income securities can help to reduce risk and provide a balanced portfolio that can weather market fluctuations.
Examples of Variable-Income Securities
The prime examples of variable-income securities include:
The Common Stock
A common stock, or a simple stock, is the smallest part of a company’s capital. When an investor buys a stock, they buy a slice of the company and become a part-owner. Shareowners have a claim over the company’s ongoing and future profits.
Stocks are the best-known form of variable income securities. There are two main ways to profit from stock investments:
Appreciation: As the company grows in value, so does the value of the stock. This depends on the market movement and the company’s accounting results. If the investor sells the stock for more than they bought it for, they end up turning a profit.
Dividends: Some shareholders may receive company profits in the form of regular dividends.
Shareowners also have certain benefits:
They can elect the board of directors
If the company can no longer meet its financial obligations and goes insolvent, or is liquidated, shareholders are entitled to receive some of its assets. But they are compensated only after preferred stockholders and other debt holders are fully paid.
Preferred stocks usually yield higher dividends than common stock, and they can be fixed or set in terms of a benchmark interest rate. Holders of preferred stocks have priority over common stockholders when it comes to dividends.
Common stocks are bought and sold on securities exchanges. The larger, US-based companies are traded on public exchanges, such as the New York Stock Exchange or NASDAQ. Whereas smaller outfits, or companies that cannot meet an exchange's listing requirements, are often traded over-the-counter (OTC).
The easiest way to buy and sell common stocks is via a brokerage account, offered by online trading platforms.
Exchange-Traded Funds
ETFs represent a basket of assets. Most ETFs are index funds, which aim to replicate the performance of a benchmark index, such as the largest 500 companies listed on US stock exchanges. Fund managers make sure that the investments don’t stray away from the performance benchmark.
These funds offer various practical advantages. They allow individuals to invest in a number of stocks without having to purchase them on paper individually. For those who are just starting out and don’t have much knowledge or experience, it’s a good introduction to investing. These are also among the most cost-effective funds to invest in, with annual administrative fees varying between 0.05% and 0.70%.
ETFs are bought and sold on securities exchanges much like common stocks and are offered by the majority of brokerages available.
Variable Income Bonds
Much of the US bond market is made up of fixed-coupon bonds, but there are also some variable income alternatives:
Floating-Rate Notes (FRN)
Floating-rate notes (FRNs) are a type of investment in the US bond market. They differ from fixed-rate bonds because their interest rate changes periodically to reflect current market rates. This means that if interest rates go up, the investor can benefit from a higher rate of return. FRNs are often linked to short-term rates set by the Federal Reserve Bank.
Due to variable rates, coupon payments are unpredictable. However, they can have a cap and a floor, which means that the investor knows the maximum and minimum interest rates they will receive. The rate can change as often as the issuer chooses, and the issuer may pay interest monthly, quarterly, semi-annually, or annually.
Compared to fixed-rate bonds, floating-rate notes tend to have less volatility in their price. This is because as interest rates rise, fixed-rate bond prices typically fall, but FRN prices are less affected since the interest rate adjusts to market conditions. However, there is still the risk that the bond's rate may underperform the overall market.
FRNs, like all bonds, carry a risk of default. This occurs when the issuer is unable to pay back the original investment amount. Everyday investors can buy FRNs via the following methods:
Through a Brokerage Account: Investors can purchase FRNs through their brokerage account. Most major online brokerage firms offer a wide range of notes from various issuers.
Directly From the Issuer: Individuals can also buy FRNs directly from the issuer through a public offering or a private placement.
Mutual Funds and ETFs: Some mutual funds or ETFs hold a diversified portfolio of notes issued by different companies. By investing in these funds, investors can gain exposure to a wide range of FRNs.
Variable Rate Demand Obligations (VRDO)
Variable Rate Demand Obligations are a type of municipal bond with a long-term nominal interest rate that is reset at short-term intervals. In other words, the interest rate on VRDOs fluctuates over time based on a money market index or short-term interest rate benchmarks.
States, cities, and other government entities issue VRDOs, often using them to finance public infrastructure projects like airports, bridges, or highways. These entities also have a low credit risk, making VRDOs a popular choice for investors looking for a steady stream of income.
Brokers and investment firms specialising in municipal bonds usually sell VRDOs. It's important to note that VRDOs are sold in large denominations. Meaning that they may not be very accessible to smaller investors.
VRDOs can also be purchased through mutual funds or exchange-traded funds (ETFs) that invest in municipal bonds. These funds allow investors to gain exposure to a diversified portfolio of VRDOs and other municipal bonds, which can help reduce the risks associated with investing in a single bond.
Benchmark interest rates are rates that financial institutions use as a reference point for setting the interest rates on things like bonds (including VRDOs and FRNs) or loans. For example, the interest rate on a bond may be tied to a benchmark rate like LIBOR, SOFR, or the Federal Funds Rate.
The Federal Funds Rate is a rate that banks use to lend and borrow money from each other overnight. It's set by a group called the Federal Open Market Committee to help the economy.
SOFR is a newer benchmark rate that's becoming more popular than LIBOR. SOFR is based on agreements that use US Treasury securities as collateral, while LIBOR was based on unsecured lending.
How to Invest in Variable Income Securities?
It’s crucial to understand what drives the financial markets before investing in variable-income securities. As we established before, the value of floating-rate assets depends primarily on market forces.
These market conditions include a company's financial performance, larger economic conditions, industry trends, and political events.
A company's financial health — When a company performs well financially, the prices of its stocks tend to increase. Conversely, negative news about the company can cause stock prices to drop.
Economic climate — Economic conditions, such as interest rates and inflation rates, also play a role in driving prices. Changes in these conditions can affect the profitability of companies and impact the prices of their stocks. They also have an impact on how much disposable income individuals have to invest in securities. As we established before, interest rates also directly impact the income you receive from variable-rate bonds.
Industry trends — Trends within specific industries can also drive stock prices up or down. For example, technological advancements can increase the value of technology stocks. Meanwhile, changing consumer preferences may reduce the value of retail stocks.
Politics — Political events, such as changes in government policies or international trade agreements, can also impact the prices of equities.
By familiarizing yourself with said market forces that drive the fluctuations in value, you can confidently make your investments and potentially your losses.
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