PART ONE: The
Very Basics of Income Investing
|In the beginning, there was
money! And the investment gods, in their infinite wisdom,
created the corporation and it's two forms of capitalization: Equity
and Debt. Corporations raise
money by selling shares of ownership called Common Stock, and by
borrowing money through a variety of instruments which range from
all forms of Bonds, Notes, and Debentures, through a similarly
confusing array of Preferred Stocks. Companies
pay investors for the use of this borrowed capital with
interest and dividends, respectively, and such payments are
expressed as Fixed Amounts that are due on specific dates throughout
the year... thus, Fixed Income Securities. Only the
income is fixed, market values of all securities do fluctuate, for
neither type of payment is guaranteed, the corporation generally
promises to pay all of its Bond Interest and Preferred Stock
Dividends before any payments can be made to Common Stockholders.
Additionally, Corporate Bonds (and Preferred Stock) may sometimes be
fully or partially insured, and/or convertible under certain circumstances into the
common stock of the issuing company. Still, Income Investing is much
safer and significantly more secure than Equity Investing and is,
therefore, one of the tools used to keep the level of overall
investment portfolio risk under control.
may also be callable, at various times, fully or partially, and
usually at face value... certainly something to be aware of when
purchasing. Is a
corporation more likely to call-in a bond or preferred
stock when interest rates are rising or falling?
thought out Asset Allocation Plans always allow for a portion of the
Investment Portfolio to be invested in Income Securities,
particularly once the six figure level has been achieved.
Article: Income Investments Save Asset Allocations
Federal Government and
its Agencies are huge issuers of notes and bonds, and Government
Fixed Income Securities are the safest and most secure of all
Income Vehicles. Both Principal (the face amount of the
security) and Interest are guaranteed by the "Full Faith and
Credit of the United States of America".
are absolutely the safest of all securities issued by any entity,
anywhere on the planet. The Income Investor must be aware that
he is accepting the lowest possible interest rate available in the
market place as part of the price of these guaranteed securities. And,
they fluctuate in market value in the same manner as
corporate and municipal securities, but are rarely called.
held to maturity, there is virtually no risk associated with them. But until maturity, Virginia,
prices of Government Securities do fluctuate... over and over
again! Yes, I wanted to repeat that!
their Agencies are also significant issuers of Fixed Income
Securities. The most important
feature of these securities, called Municipal Bonds, is that the interest
they pay to investors is totally exempt from Federal (and Home
State) Income Taxes. There have been an insignificant number of defaults in
United States Municipal Bond history, and those few have nearly
always involved Revenue Bonds.
Obligation bonds are generally considered to be nearly as safe as
Federally issued Fixed Income Securities. As with Corporate Bonds,
investors must look to the Bond Rating and the current yield of the
bond itself to determine the quality of the issue. A suspiciously
high yield should be an indicator to the investor of increased risk.
When held to maturity, there is
virtually no risk associated with these securities. Still, many
Municipal Bond issues are insured as to principal, interest, or both, thus assuring an
even lower yield to the investor. Investors
pay dearly for each level of protection they require, and experience
will teach you that insurance and the accompanying AAA rating is
|Investors can also obtain
shares of Investment Company Closed End
Mutual Funds (CEFs) that invest in all of the
securities mentioned above in many different ways, and Industry Specific
Income Securities that
specialize in various kinds of royalties, all kinds of
commercial, residential, and industrial Real Estate, and Mortgage
Income. There are right and wrong
(high risk vs. lower risk) ways of investing in theses types of
securities as well, and they have become the security of choice for Sanco Services because of
their liquidity, ease of
trading on the NYSE, monthly cash flow, etc.
In higher interest
rate environments, individual Preferred Stocks, and Bond Unit Trusts
(Corporate and Government) become more attractive than they are at
Income Securities are Interest Rate Expectation Sensitive securities, and as such, their
market price will always vary inversely to the
anticipated direction of interest rates.
WHAT! In the simplest of terms, this
means that all Bond, Preferred Stock, REIT (Real Estate Investment
Trusts), etc. prices will rise in market value when lower interest rates are
expected and fall if higher interest rates are anticipated. The
amount of movement in the price of these Interest Rate Sensitive, Income Securities, will vary depending on: the
of the Issuer of the Security, and the amount of time until the
Maturity, or Call Date (if applicable) of the issue. Sector
specific CEFs will also react to expectations other than those
affecting interest rates... even more so.
Income Security Prices themselves have no impact either on the
actual Quality of the securities or the ability of issuers to pay
interest. Therefore, it is critical to investors that they learn to
take advantage of lower prices/higher yields rather than to lose
sleep over them! This seems to be a whole lot more difficult than it
sounds. In and of itself,
in all the years that I have tended to people's investment
portfolios, this is the area where the most investment errors are
made, and simply out of ignorance.
| Income Securities are,
by their very nature, Long Term Holdings, AND for a myriad of
reasons, higher interest rates, in recent years, have generally been
associated with longer maturity dates. The
key issue in Income Investing is the amount of income being
received. Guess work about the future direction of interest rates is
something that should be avoided. Similarly, the Income
portion of a portfolio must be Performance Analyzed separate and
apart from the Equity portion of the portfolio.
At the top
of the Sidebar to your left are links to three recent
articles on Income Investing: Expectations, Selection, and
TWO: Understanding Fixed Income Securities
|The purpose of owning
Income Securities is quite simply the generation of a secure
flow that can either be spent or reinvested at prevailing interest
rates (i.e., compounded) until it is needed.
The classical long term goal of an
Investment Program is to live off
the income produced by one's assets, without ever having to invade
the principal. Therefore,
it should be clear that it is never smart, or savvy either to defer the receipt of income for any
reason, ever, or to put off the development of the income stream
until the last minute. This is part
of what Asset Allocation is all about! Done
using the Working Capital Model,
it assures the constant growth of the income contribution to the
Investing in Income Securities is never a
against something that may or may not happen in the future, nor is
it a place to stash your stash until some other event takes place. Investment
Income comes in just two varieties: interest on debt securities and
dividends on stocks and other hybrid securities, such
as Preferred Stocks and Closed End Mutual Funds/Investment Companies
that are distributed to investors in the form of Equities. Capital
Gains income is a real possibility as well, but it is not considered
part of the Fixed, Base Income. Rents and royalties can
be classified as fixed and/or variable income.
|Income Investing has
always been the orphan of the Investment World because it just
doesn't generate the hype and excitement that the "Shock"
Market routinely provides. Still,
it is important for investors to understand that there is as much of
a need for income in the day to day or short run of
running an investment portfolio as there is the obvious need for
income in a person's retirement years.
Income Securities generally trade in larger dollar
quantities than stocks, particularly when initially sold to the
public, and the mark up on them is both invisible and
huge... upwards of 3% in most instances. Many
Fixed Income Securities are placed directly with (sold to) mutual
funds, insurance companies, investment companies, and other
entities which will package (even restructure) them for sale to the
Individual Investor in some form of Income Product. Government Agencies do the same, particularly with
respect to mortgage investments.
the most part, individual investors have to rely upon their advisors
to guide them in their selection of appropriate Income Investments where, believe it or not,
there is more room
for mistakes, ignorance, misinformed advice, inexperience, and
general confusion than there is in the Equity Market. The
reason for this is that mark-ups are not revealed in transactions, and
both investors and their advisors have many misconceptions about
these investment vehicles.
Income Yields and security prices generally change much more slowly
than Stock Market prices, and it can actually takes years
for interest rates to move in either direction by a few points. At
the same time, a trend in interest movements is likely to last longer
than a trend in stock prices. There is abundantly more economics
than there is emotion involved with interest rates movements,
creating a more stable playing field for the individual
Income Investing should be much easier than it is, and should rarely
produce an anxious moment. If you are thinking long term, as you
should be in this area, the rules become simple and few:
- RULE ONE is
to always seek out the longest duration, Investment
Grade Only, securities with the highest (reasonable)
- So long as you follow
RULE ONE, RULE TWO is to
focus on the Cost Basis of your Fixed Income Securities and ignore
their Market Value fluctuations.
- RULE THREE
is to stay focused on the income generated by these securities,
and to make decisions that grow that income annually.
Interest Rate Sensitive Securities are Created Equal... pretty
means that if your bonds are up or down in price, so are everyone
else's. If your fund is down, Johnny's fund couldn't do better
unless there are significant Quality or Duration differences
involved. Therefore, don't ever switch from one Fixed Income Security to
another for emotional (fear or greed) or other similarly superficial
should almost never switch from one fixed income fund to another, OR
worse, take losses on fixed income to move into something else
entirely, typically a peaking Equity Market.
- Another basic
rule is to avoid yields that are a great deal higher than normal.
one sense, Fixed Income Investing and Equity Investing are
identical...Junk is Junk.
To be a successful Fixed Income Investor
you must get to the point where you understand that:
- Higher Interest Rates are a Good
- So, too, are Lower Interest Rates.
THREE: The Delivery System for Fixed Income Securities
firms have the responsibility to explain to you just how stable, predictable, fair, and understandable
Income Investing really is, in it's purist form. They want you to appreciate the simplicity of the
security price vs. interest rate relationship. Financial
- Explain how
foolish it is to attempt to guess
either the extent or the duration of an interest rate cycle.
- Identify and
point out all of the barely visible costs associated with the
purchase of Individual Bonds, newly issued Preferred Stocks, and
Investment Company IPOs.
- Discuss with investors the variety of
fixed income alternatives that are available without the
illiquidity, costs, and complexities of more expensive income
understand the long term nature of Fixed Income Securities, so they should
be able to explain that it makes little sense to:
the market value of such securities in performance evaluation
- to be concerned
with anything other than safety and reinvestment of the income
that they generate.
will caution their clients to avoid low yielding short term
bonds and Preferred
Stocks, and Open Ended Mutual Funds with complicated hedging
strategies designed to smooth the interest rate
curve. They should also advise you to avoid schemes
- involve, or are
focused on, an avoidance of Market Value fluctuation through the
use of short term issues,
- or that involve
new issue Preferred Stocks.
One other thing to
avoid with regard to Fixed Income Securities is any form of Total
Return Analysis. You'll get three smiley faces on your
portfolio management report card if you understand why.
some financial professionals have not been properly prepared to
deal with the nature of Income Securities and are somewhat
unfamiliar with alternatives to the standard Open End (Conventional)
Mutual Fund. There
are four common forms in which Fixed Income Securities find their
way into Investment Portfolios: Individual Securities; Open Ended
Mutual Funds, Closed End Funds, and Unit Trusts.
the Stock Market, it is decidedly wiser to use individual securities
nearly all of the time. But when dealing with most Fixed Income
Securities, there are some other variables in the mix that are
impossible to predict or to control efficiently. Call dates and
partial redemptions come to mind as the most frequent issues that
may have to be addressed with individual securities. Odd lot
pricing is another. Using
managed programs make a whole lot of sense in this area, just like
REITs and Royalty Trusts are easier for you and me (somewhat normal
folk) than owning apartment houses and drilling rigs.
But they have to
be managed by professionals, not by your fellow 401(k) and IRA
participants. Conventional Mutual Funds are, in reality, not
managed; Closed End Mutual Funds are.
individual bonds, and be careful with individual issues of Preferred
Stocks as well. Very few individual portfolios can support a round lot bond purchase and remain properly diversified.
Such securities are generally illiquid, and rarely sell for the
asking price indicated on brokerage account statements. When dealing with
quality issues, you can always do better in terms of yield and
safety with Closed End Mutual Funds.
Buying Preferred shares
directly on the exchanges is the best approach, but in low or
falling interest rate environments, the higher yielding issues will
likely be called away from you. This is also true of individual
Try to never pay a premium (more
than the face amount) for any individual Fixed Income Security.
|Open Ended (Normal Net Asset
Value) Mutual Funds: It's always a
good idea to avoid Mutual Funds, and it is common knowledge that the
fixed income variety almost never go up! During the last several
years (through 2004) of tumbling interest rates, Fixed Income Mutual Fund shares
just never participated in the upward price movement experienced by
individual securities, Unit Trusts, and Closed End Funds.
|Closed End Funds:
the place you want to be for a large variety of reasons. Low
acquisition costs, instant diversification, total
professional fund management unaffected by Market Hype, monthly
predictable cash flow, the ability to buy more when prices fall and
to take profits when interest rates tumble. Additionally, you can
diversify into all types of fixed income areas, both taxable and tax
free. You can even select insured instruments if you choose to.
securities always offer a significantly higher yield than individual
securities, because the securities inside are purchased
directly from the issuer, or in bulk.
The Investment Companies
that manage these funds use varying degrees of leverage
to enhance the yield, but the amount of borrowing is published for
investor's to research before any commitment is made. Unleveraged
funds (lower yielding), shorter duration funds (also lower
yielding), and insured funds (yes, lower yielding) can also be
try not to be concerned about the somewhat scary term leverage... it does have more than four letters, after
all. All businesses use leverage (borrowing) to finance their
operations. The borrowing is short term, and not a requirement. It's
only used if there is an economic benefit. You wouldn't borrow at 7%
to earn 4% and neither would these managers.
unfortunate that many professionals are unaware of the benefits
these securities offer to investors. In 2004,
they were yielding a safe 6% to 7%
while most investors were crying about yields of less than 2%. They
seem to always produce more income than individual holdings. (Note that
index funds and ishare type speculations are not appropriate for
are excellent alternatives to an assortment of individual bond odd
lots, particularly in rising interest
rate environments, because they regularly return principal that can
be reinvested later (if you don't spend it by mistake) at higher
rates. They are available for all
forms of Fixed Income Securities, but are not nearly as liquid as
Closed End Funds. They are particularly good for investing in
Corporate Bonds, Ginny Maes, and Preferred Stocks.
interest rate environments, look for packaged unit trusts that have
been selected especially for protection from premature calls.
End Funds and Unit Trusts are always available and your financial
professional will be happy to find appropriate ones for you. You
should ask for them, and insist that you are sure that the yields
will be higher than with individual issues and Mutual Funds.
Remember, you are
after spendable income, not Total Return. Hey, it's your
money and you deserve the best.
|Remember, to be a successful
Fixed Income Investor you must get to the point where you understand
- Higher Interest Rates are a Good
- So, too, are Lower Interest Rates.
ARE YOU THERE
YET? No, keep trying...
FOR PARTS IV - VI)
Part Four: Managing the Fixed Income Portfolio
Part Five: Asset Allocation
& The Fixed Income Portfolio
Part Six: Links
to Fixed Income Security Information Web Sites