I’ve 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 won’t consider taking
profits when prices increase, but will rush in to accept losses when prices
fall.
Here are the important characteristics of Fixed Income
Securities:
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 investor’s
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.”
It’s OK, it’s natural, it just doesn’t matter, I say to
disbelieving audiences everywhere. You have to understand how these securities
react to interest rate expectations and take advantage of it. There’s no need
to hedge against it, or to cry about it. It’s simply the nature of things. This
is the first of three successive articles I’ll be writing about Fixed Income
Investing. If I don’t 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 don’t 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 it’s 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 cyclical change.
Here’s 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 “let’s try to be happy with our investment
portfolio because it’s 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. It’s like magic, or is it justice. Both sides of the scales contain
good news for the investor… as the investment gods intended.
Steve
Selengut
http://www.sancoservices.com
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor: The Book that Wall
Street Does Not Want YOU to Read", and "A Millionaire's Secret
Investment Strategy"