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Income Investing Articles:

Managing Income Portfolios

Selecting the Right Stuff

Expectations

The "Total Return" Shell Game

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Investment Performance

Social Security Reform 

The Fair Tax  

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A Millionaire's Secret Investment Strategy

The Stock Market - - - A Challenge for Professionals

Portfolio Content Analysis

Wall Street Transcript and Charleston Regional Business Journal Interviews with Manager Steve Selengut

Operational Questions & Answers

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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 various reasons..

Although 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. 

Income securities 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?

Well 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. 

New Article: Income Investments Save Asset Allocations

The 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". 

These 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.

When 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!

States, Municipalities, and 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

Municipal General 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 overkill.

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 lower rates.

All 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 Quality Rating 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.
Note: At the top of the Sidebar to your left are links to three recent articles on Income Investing: Expectations, Selection, and Management. 

PART TWO: Understanding Fixed Income Securities

The purpose of owning Income Securities is quite simply the generation of a secure cash 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 portfolio.

Investing in Income Securities is never a hedge 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.

For 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.

Fixed 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 investor... theoretically.

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) yields. 
  • 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.
All Interest Rate Sensitive Securities are Created Equal... pretty much! This 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 reasons. 
  • Investors should almost never switch from one fixed income fund to another, OR even 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. Caveat Emptor! In 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 Thing, and
  • So, too, are Lower Interest Rates.

PART THREE: The Delivery System for Fixed Income Securities

Wall Street firms have the responsibility to explain to you just how stable, predictable, fair, and understandable Fixed 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 Professionals should: 
  • 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 investment possibilities.

Do they?

Financial Professionals understand the long term nature of Fixed Income Securities, so they should be able to explain that it makes little sense to:
  • include the market value of such securities in performance evaluation scenarios, or
  • to be concerned with anything other than safety and reinvestment of the income that they generate.

Most professionals 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 that: 

  • 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.

Unfortunately, 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.

In 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 bond 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 Securities: Avoid 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 bonds. 

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: This the place you want to be for a large variety of reasons. Low acquisition costs, instant diversification, total liquidity, 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.

These 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 obtained.

 Please 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.

It's 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 income investing.)

Unit Trusts: These 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.

In low interest rate environments, look for packaged unit trusts that have been selected especially for protection from premature calls.

Closed 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 that:
  • Higher Interest Rates are a Good Thing, and
  • So, too, are Lower Interest Rates.

ARE YOU THERE YET?  No, keep trying...

 

(CLICK 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