FIXED INCOME INVESTMENTS ARE A RELIABLE ADDITION TO ANY PORTFOLIO
Fixed income investments might not have the same blood-pumping, frenetic energy of the stock market, but they attract some of the best and brightest portfolio managers. To many, fixed income investing is the dull but necessary side of one’s investment portfolio; however, I’ll gladly take these tried-but-true assets in a crisis.
Keep in mind that it wasn’t a stock market crash that led to the 2008 financial crisis; it was the drying up of liquidity in the residential mortgage-backed securities and commercial mortgage-backed securities markets that caused the panic. Surely the financial crisis, which started after the mortgage securities collapse and spread throughout the entire U.S. economy and through all forms of financial products, was to blame. The root cause of the Great Recession was the dry, boring world of fixed income investing.
Congress and the Obama administration thought we could avoid a repeat of the Great Recession by passing the Dodd-Frank Wall Street Reform and Consumer Protection Act. I would suggest that instead we need a combination of sensible regulation and a knowledgeable investor. So what should every investor know about investing in bonds?
First, it is important to understand what a fixed income security is — nothing more than a loan from the investor to a government or corporation. A bond is a promise to repay a set amount on a set date, as well as a promise to pay interest periodically throughout the lifetime of the loan. The most common types of bonds are Treasury bills, municipal bonds, corporate bonds, preferred stock and certificates of deposit. The key to understanding a bond and its risks is to first understand the lingo. The face amount (or par) value of the bond is merely the principle amount loaned to the borrower by the investor. The coupon, or rate, is the interest rate the borrower promises to pay, and the maturity date is the date in the future that the borrower promises to repay the face amount. Interestingly, the market value of a bond will fluctuate over the course of its lifetime due to many factors — like the credit standing of the borrower or the coupon when compared to current interest rates — but at maturity, the face amount is due in full. The duration of a fixed income investment is the expected life of the bond when compared to the maturity date. The best example of expected duration is the residential mortgage-backed security. The bond itself might have a 30-year maturity date, but as the underlying mortgages back up the bond are paid down or paid off, the actual time till maturity might be much shorter.
The most significant risk associated with fixed income investing comes in the form of credit risk. The U.S. Treasury bill is generally considered a proxy for zero credit default risk. As an example, the 10-year Treasury bill has recently been trading at a 2.3 percent risk-free rate. Compare that to a corporate “junk” bond that trades at 8 percent with the same maturity date. The difference of 5.7 percent represents the credit default risk premium. It is important for fixed income investors to pay particular attention to the likelihood of default when making investment decisions.
One way to mitigate the risk of fixed income investing is to look to bond funds as opposed to investing in individual bonds. The best-known bond funds are managed by seasoned bond portfolio managers who work for firms like PIMCO or Blackrock, which are among the largest fixed income managers in the world. In bond funds, individual investors invest in a pool of securities. Professional managers then invest in pools of bonds that best reflect the risks and opportunities described in their investment goals as stated in their prospectus. Bond funds have the diversification that can’t be achieved by individual investors investing in individual bonds.
So who should consider investing in fixed income assets? The answer to that question is everyone: All serious investors should have a well-diversified pool of assets that includes fixed income assets, equities, real estate holdings and commodities. It is important for all investors to seek advice from well-trained and experienced financial advisers. These professionals will work with you to determine your tolerance for risk and will help you build a portfolio that can withstand market volatility.
Elihu Spencer is a local amateur economist with a long business history in global finance. His life work has been centered on understanding credit cycles and their impact on local economies. The information contained in this article has been obtained from sources considered reliable but the accuracy cannot be guaranteed.