Fixed Income Investing - Part II

By Nancy Zambell, Contributing Editor, Financially Fit

Last week, we discussed the differences between equity and fixed income investments, including voting rights, liquidation order and taxation advantages. We also talked about the important role that fixed income plays in adding diversification and reducing the overall risk of your portfolios. And lastly we discussed the various risks inherent to fixed income investing, as well as which resources to use in determining the ratings on bonds.

In this issue of Financially Fit, I want to give you an overview of the many types of fixed income and hybrid (equity/fixed income) investments that are available in the marketplace.

Bonds are an excellent way to add income to your portfolio

As I mentioned in last week's issue, bonds are essentially loans wherein the federal government or its agencies, individual states, cities and counties, or corporations borrow money to fund various projects. In return, these entities pay interest to bondholders.

The federal government issues treasury bonds, bills and notes. The maturity periods are as follows:  Bills: 90 days to 1 year; notes: 1 to 10 years; and bonds: more than 10 years.

These are the safest bonds, with no credit risk, as they are backed by the full faith and credit of the U.S. government. In addition, U.S. government agencies such as Fannie Mae, Freddie Mac and Sallie Mae also issue fixed income investments. While they are the next safest in line, they are not backed by the full faith and credit of the U.S. government, so do incur some credit risk.

Municipal authorities such as states, cities and counties also issue bonds, either revenue or general. The cash flow from general bonds is used to fund operations, while revenue bonds generate funds for specific projects, such as a toll road, or water plant. A big advantage for municipal bonds is that the interest you earn is not taxed at the federal level. Additionally, many states and municipalities also exempt their residents from local taxes on earnings. However, since they are tax-free (at least at the Federal level), the interest paid is generally lower than that paid on a taxable bond.

Moving down the safety ladder, next are corporate bonds. The key point to remember here is that the default risk of the bond is directly correlated to the financial health of the issuing corporation. The stronger the company, the higher rating its bonds will receive, and the lower the coupon rate it will pay. As I noted last week, there is a distinct relationship between rate and risk. In order to compensate holders of riskier bonds, issuers must pay a higher rate, or investors would not buy the bonds.

Consequently, junk, or speculative, bonds will usually pay fairly high rates of interest.

One of the disadvantages to purchasing bonds is that an investor must have a decent stack of cash - usually a minimum of at least $5,000. And that's where bond funds come into play. In addition to the ability to find funds with low minimum initial purchases, there are several other advantages to bond funds:

·        Managed by professional managers, who have teams of analysts researching and reviewing the companies that issue the bonds

·        Tend to be less volatile than funds that invest in equities

·        Add significant diversification to your portfolio

·        Reinvesting interest payments in bond funds is much easier than attempting to do so when purchasing individual bonds, due to the minimum purchase amounts required in buying individual issues

However, investors do need to be aware that when buying bond funds, you generally are not holding the bonds to maturity; therefore, the return of your principal is not guaranteed. Remember, bond prices fluctuate with the change in interest rates. Higher interest rates mean a decline in prices, so if a fund manager sells the bonds prior to maturity in a rising rate market, there will be some erosion of principal.

Savings bonds are familiar to most investors and for years have been a mainstay for grandparents seeking to set aside college tuition money for their grandchildren. But although so many additional educational savings plans are on the landscape today, savings bonds still remain a viable investment vehicle for millions of folks. Easily purchased at your local financial institution, or even through payroll deduction, they are risk-free promises by the U.S. Treasury and earn a market-based interest rate if held to maturity.

But bonds are not the only investment vehicles that pay investors back with a premium above the expected rate of appreciation.

Hybrid investments - combinations of fixed income plus equity can also add diversification + income to your portfolio

In addition to common stocks, many corporations also issue preferred stocks. Technically, they are equities that pay a fixed dividend (not always guaranteed), based on a percentage of the face value of the instrument. They have several factors in common with bonds: 1) Their prices will fluctuate inversely with interest rates, although usually less dramatically; 2) They may be called; and 3) They are rated by the rating agencies.

In matters of liquidation, preferred stocks are senior to common stocks, but junior to bonds. They are sometimes convertible to common stock, but generally lack the voting rights of common shareholders, and also tend to be less volatile than common stocks. Most preferred shares are cumulative, meaning that if a dividend is skipped at any point in time, it must be accrued and paid at a later date.

Real estate investment trusts (REITs), while classified as equities, generally pay fairly high dividends, as they return the majority of the income from their investments in real properties to their unit holders, in the form of distributions. They are pass-through securities, so the dividends are not taxed at the corporate level, just when they hit your pocketbook.

Special purpose financing vehicles, such as unit and income royalty trusts are also pass-through vehicles, which usually pay very high yields, lately in excess of 10% annually. Many are energy-related and subject to swings in commodity prices. They trade like equities, but are accompanied by significant tax benefits as a significant portion of their distributions are often considered as return of principal, not income.

One additional pass-through vehicle is the Master Limited Partnership (MLP), also generally energy-related, but with a few exceptions, including an amusement park, a jet aircraft owner and a macadamia nut grower that were grandfathered in. Like REITs and unit and income royalty trusts, MLPs return the bulk of their income to their unit holders, part of which is treated as depreciation which decreases the tax liability.

When most investors think of fixed income securities, bonds come to mind, and only in conjunction to their planned investments in their retirement years. Yet, you can see that the category has widened to include many additional fixed income and hybrid instruments that may be desirable at any age.

And while high rates of interest and/or dividends can be very attractive - especially in a volatile equity market - please remember that it's the company that counts. That means performing your due diligence to ascertain that the company underlying the investment is healthy and strong with the potential to continue growing its sales and earnings.

Therefore, you should perform the same analysis that you would execute before purchasing any other investment. And then make sure that the expected risk is commensurate with your own risk profile and that the maturity matches your investment needs. Then, you're on your way to building a nicely diversified portfolio.

Until next week…

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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