Rethinking Fixed Income Investing

March 6, 2013 - PRLog -- A fixed income investment is one that provides the investor with a series of periodic payments and the promise of the return of principal at maturity. The price of such investments moves inversely to prevailing interest rates. This means that when interest rates are falling the price of these investments increases and conversely when interest rates are increasing the value of these instruments decreases. Certificates of deposits and bonds are two of the more common forms of fixed income investments.  There are four basic reasons for making a fixed income investment:
1.   For capital preservation
2.   For a predetermined stream of income
3.   For capital appreciation
4.   For two or more of the preceding.
Those investing for capital preservation are dependent on the issuer’s ability to honor its obligations over the specified time period. The longer the time until the instrument matures even the most credit worthy issuers may be unable to honor their commitments. The bonds of General Motors, Eastman Kodak, Lehman Bros, etc. were once considered to be investment grade.  Yet each of these companies was forced to default on their obligations on their fixed income instruments. For those investors whose primary objective is capital preservation certificates of deposit (CDs) that are guaranteed by the FDIC (Federal Deposit Insurance Corporation) and Treasuries that are backed by the full faith and credit of the United States Treasury are the only fixed income instruments in which to commit funds.  For those who do not believe in the government’s ability to honor its guarantees the only truly safe option is to keep their funds under their mattress or in a safe deposit box.
Currently one year certificates of deposit are yielding around 1.0 percent; three month Treasury Bills  0.05 percent. With the current rate of inflation of around 2.0 percent, these instruments produce negative real returns (yield minus inflation) of 1.0 and 1.95 percent respectively. Investors concerned about capital preservation would find that ten year Treasury Bonds with their yield of 2.97 percent would produce real return of almost 1.0 percent assuming inflation does not exceed 2.0 percent.   For corporate bonds with the same duration rated AAA yield 2.46 percent; rated AA 2.94 percent; and rated A 3.03 percent.  These  yields do not compensate the investor for the potential default of the issuer.  Lower rated  bonds offer higher yields which by their nature have higher risk of default. Other sources of income include preferred stocks, REITs (Real Estate Investment Trusts), and MLPs (Master Limited Partnerships). They provide higher rates of returns that may or may not be sustainable and even the possibility of a loss of principal. It should be noted that while TIPS (Treasury Inflations-Protected Securities) can protect investors from the loss of purchasing power, there is no corresponding inflation protection for other fixed income investments.
The price of a fixed income instrument adjusts to reflect current interest rates.  Since the financial crisis of 2007, the Federal Reserve Board has reduced the Federal Funds Rate to 0.25 percent and increased its balance sheet by buying longer term Treasuries in order to decrease long term interest rates. The net effect of these actions has been to increase the price of the affected fixed income instruments.  This has provided investors with capital gains from  their investments.  When, and not if, the Fed increases interest rates, the price of these instruments will decrease to reflect current market conditions. As a result, investors will experience capital losses not the capital gains they had become accustomed to. It should be noted that  investors who hold their fixed income instrument until maturity will receive the specified return of principal which may or may not produce a gain or loss depending on the price that they initially paid.
Most investors choose a fixed income investment for one or more of the reasons discussed above. If no other reason than to diversify one’s investments, fixed income should have a place in one’s portfolio.  The shorter the timeframe within which funds are needed, safety of principal should be the primary concern. The longer the timeframe, the more risk one can take.  For those whom current income is the primary motivation, today’s interest rates offered by certificates of deposits and Treasuries are insufficient for most investors. Today’s 1.0 percent yield from CDs means that one would need five times as much invested in  them than when they were yielding in excess of 5.0 percent as recently as 2007. Even worse, one would need one hundred times as much invested in Treasury Bills than in 2007 when they too were yielding in excess of 5.0 percent. As with all investments, potential fixed income investors must balance the risks with the benefits.
A more detailed discussion of the relative advantages and disadvantages of fixed income investments can be found in “A Common Sense Approach to Successful Investing.”

About The Author
Marvin H. Doniger has been an avid investor since his early teens. During the course of his lifetime he has developed a philosophy that has served him in his own professional development and in the creation of an investment portfolio for his family’s financial needs. His perspectives have been developed from his lifelong study of investing, his actual experiences as a registered representative, an individual investor, as well as from working for large companies in industry and as a management consultant to Fortune 500 companies.
He is the author of A Common Sense Road Map to Uncommon Wealth, which is a treatise on managing careers and finances, A Common Sense Approach to Successful Investing, in which he first introduced stratamentical analysis, a unique approach for identifying long-term investment opportunities, and Common Sense Prescriptions for Financial Health which presents quaestrology, a unique perspective on managing one’s finances. He is also a regular guest on the Business Talk Radio Network and other radio shows. His articles have been published in media outlets such as Investor’s Digest of Canada and Morningstar.
Mr. Doniger received a Masters in Business Administration from Columbia University Graduate School of Business and a Bachelor of Science Degree in Mechanical Engineering from Tufts University. He has taught undergraduate and graduate level courses in production control, inventory management, information technology and finance at Fitchburg State College and Webster University. He currently resides with his wife, Marsha, in Laguna, California