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. 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.”
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.
