Iíve come to the conclusion that the Stock Market
is an easier medium for investors to understand (i.e., to form behavioral
expectations about) than the Fixed Income Market. As unlikely as this
sounds, experience proves it, irrefutably. Few investors grow to love
volatility as I do, but most expect it in the Market Value of their equity
positions. When dealing with Fixed Income Securities however, neither they
nor their advisors are comfortable with any downward movement at all. Most
wonít consider taking profits when prices increase, but will rush in to
accept losses when prices fall.
Theoretically, Fixed Income Securities should be
the ultimate Buy and Hold; their primary purpose is income generation, and
return of principal is typically a contractual obligation. I like to add
some seasoning to this bland diet, through profit taking whenever possible,
but losses are almost never an acceptable, or necessary, menu item. Still,
Wall Street pumps out products and Investment Experts rationalize
strategies that cloud the simple rules governing the behavior of what
should be an investorís retirement blankie. I shake my head in disbelief,
constantly. The investment gods have spoken: "The market price of Fixed
Income Securities shall vary inversely with Interest Rates, both actual and
anticipated... and it is good."
Itís OK, itís natural, it just doesnít matter, I
say to disbelieving audiences everywhere. You have to understand how these
securities react to interest rate expectations and take advantage of it.
Thereís no need to hedge against it, or to cry about it. Itís simply the
nature of things. This is the first of three successive articles Iíll be
writing about Fixed Income Investing. If I donít improve your comfort level
with this effort, perhaps the next one will strike the proper chord.
There are several reasons why investors have
invalid expectations about their Fixed Income investments: (1) They donít
experience this type of investing until retirement planning time and they
view all securities with an eye on Market Value, as they have been
programmed to do by Wall Street. (2) The combination of increasing age and
inexperience creates an inordinate fear of loss that is prayed upon by
commissioned sales persons of all shapes and sizes. (3) They have trouble
distinguishing between the income generating purpose of Fixed Income
Securities and the fact that they are negotiable instruments with a Market
Value that is a function of current, as opposed to contractual, interest
rates. (4) They have been brainwashed into believing that the Market Value
of their portfolio, and not the income that it generates, is their primary
weapon against inflation. [Really, Alice, if you held these securities in a
safe deposit box instead of a brokerage account, and just received the
income, the perception of loss, the fear, and the rush to make a change
would simply disappear. Think about it.]
Every properly constructed portfolio will contain
securities whose primary purpose is to generate income (fixed and/or
variable), and every investor must understand some basic and "absolute"
characteristics of Interest Rate Sensitive Securities. These securities
include Corporate, Government, and Municipal Bonds, Preferred Stocks, many
Closed End Funds, Unit Trusts, REITs, Royalty Trusts, Treasury Securities,
etc. Most are legally binding contracts between the owner of the securities
(you, or an Investment Company that you own a piece of) and an entity that
promises to pay a Fixed Rate of Interest for the use of the money. They are
primary debts of the issuer, and must be paid before all other obligations.
They are negotiable, meaning that they can be bought and sold, at a price
that varies with current interest rates. The longer the duration of the
obligation, the more price fluctuation cycles will occur during the holding
period. Typically, longer obligations also have higher interest rates. Two
things are accomplished by buying shorter duration securities: you earn
less interest and you pay your broker a commission more frequently.
Defaults in interest payments are extremely rare,
particularly in Investment Grade Securities, and it is very likely that you
will receive a predictable, constant, and gradually increasing flow of
Income. (The income will increase gradually only if you manage your asset
allocation properly by adding proportionately to your Fixed Income
holdings.) So, if everything is going according to plan, all that you ever
need to look at is the amount of income that your Fixed Income portfolio is
generating... period. Dealing with variable income securities is slightly
different, as Market Value will also vary with the nature of the income,
and the economics of a particular industry. REITs, Royalty Trusts, Unit
Trusts, and even CEFs (Closed End Funds) may have variable income levels
and portfolio management requires an understanding of the risks involved. A
Municipal Bond CEF, for example will have a much more dependable cash flow
and considerably more price stability than an oil and gas Royalty Trust.
Thus, diversification in the income-generating portion of the portfolio is
even more important than in the growth portion... income pays the bills.
Never lose sight of that fact and you will be able to go fishing more
frequently in retirement.
The critical relationship between the two classes
of securities in your portfolio, is this: The Market Value of your Equity
Investments and that of your Fixed Income investments are totally, and
completely unrelated. Each Market dances to itís own beat. Stocks are like
heavy metal or Rap...impossible to predict. Bonds are more like the classics
and old time rock-and-roll...much more predictable. Thus, for the sake of
portfolio smile maintenance, you must develop the ability to separate the
two classes of securities, mentally, if not physically. For example, if
your July 2005 Market Value fell, it was because of higher interest rates
not lower stock prices. More recently, the combination of higher rates and
a weaker Stock Market has been a Double Whammy for portfolio Market Values,
and a double bonanza for investment opportunities. Just like at the Mall,
lower securities prices are a good thing for buyers... and higher prices are
a good thing for sellers. You need to act on these things with each
Hereís a simple way to deal with Fixed Income
Market Values to avoid shocks and surprises. Just visualize the Scales of
Justice, with or without the blindfold. On one side we have a number that
represents the Current Market Value of your Fixed Income portfolio. On the
other side, we have a small "i" for interest rates, and "up" or "down"
arrows that represent interest rate directional expectations. If the world
expects interest rates to rise, or even to stop going down, "up" arrows are
added to "i" and the Market Value side moves lower... the current scenario.
Absolutely nothing can (or should) be done about it. It has no impact at
all on the contracts you hold or the interest that you will receive;
neither the maturity value nor the cash flow is affected... but your broker
just called with an idea.
The mechanics are also simple. These are negotiable
securities that carry a fixed interest rate. Buyers are entitled to current
rates, and the only way to provide them on an existing security is to sell
it at a discount. Fortunately, one rarely has to sell. Over the past few
years of falling interest rates, Fixed Income securities have risen in
price and investors (should) have realized capital gains as a result...adding
to portfolio income and Working Capital. Now, that trend has reversed
itself and you have the opportunity to add to existing holdings, or to buy
new securities, at lower prices and higher interest rates. This cycle will
be repeated forever.
So, from a "letís try to be happy with our
investment portfolio because itís financially healthier" standpoint, it is
critical that you understand changes in Market Value, anticipate them, and
appreciate the opportunities that they provide. Comparing your portfolio
Market Value with some external and unrelated number accomplishes nothing.
Actually, owning your fixed income securities in the most freely negotiable
manner possible can put you in a unique position. You have no increased
risk from a reduction in security prices, while you gain the ability to add
to holdings at higher yields. Itís like magic, or is it justice. Both sides
of the scales contain good news for the investor... as the investment gods