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.
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
sanserve@aol.com
800-245-0494
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"
