Know Your Fixed Income Choices
We generally use these columns to discuss stocks, options, or matters of general personal finance. However, today I want to talk about something that’s of interest to more conservative investors: Fixed income offerings.
This is a topic I have been writing a lot about lately for Utility Forecaster, and I thought some of the basics could be of interest to a broader audience. The following is a condensed version of a recent article on fixed income offerings that I wrote for Utility Forecaster.
What are Fixed Income Securities?
Fixed income securities offer the purchaser a fixed income rate, typically until some maturity date. The issuer of the fixed income security uses these securities to raise money for day-to-day operations and finance large projects.
Common types of fixed income securities are government and corporate bonds, certificates of deposit (CDs), and preferred stock (more on these below).
Who Needs Fixed Income?
Fixed income securities are appropriate for anyone that relies on investment income for any purpose, and who must minimize risks to capital. This is distinct from those who are attempting to build their wealth over time, in which case they would want to invest in more aggressive securities.
Retirees typically count themselves as fixed income investors. However, most people, retired or not, should shift their portfolio toward fixed income choices as they approach their retirement years. It could take years to recover from a major bear stock market, but you can significantly reduce risk in your portfolio as you approach retirement by increasing the percentage devoted to fixed income.
What are the Risks?
Even though the risks of fixed income securities are low compared to stocks, there are some risks. The single biggest risk is that your yields fail to keep up with inflation.
For example, at present the annual inflation rate in the U.S. is running at about 2%. This means that on average, you will have to pay 2% more each year for the goods and services you purchase.
Now, consider the yield from various fixed income offerings. Most CDs and bonds with the highest credit ratings will yield less than 2%. If your retirement savings are invested in such securities, the value of your savings will decline over time.
However, it is possible to buy a bond today that yields 7.5%. That brings me to the second area of risk. High-yielding bonds like this fall into two classes. The first consists of companies with a higher credit risk, and thus a lower credit rating. The reason these bonds yield more money is that the investor is assuming a higher risk of default, which means the possibility of losing their entire investment. That’s a nightmare scenario for a fixed income investor and a good reason to avoid these “junk bonds.”
Another risk comes in the form of bonds that are “callable.” This means that the issuer can redeem them at a specific price and on a specific date.
Let’s say a bond at $25 yielded 6% when it was issued. That means annual interest rate payments of $1.50 (6% of $25) for each bond you own. But let’s say interest rates have risen, and the bond is now being traded at $28. You can buy this bond for $28 and receive an effective interest rate of 5.36% ($1.50/$28.00).
However, if that bond is currently callable, you could see it redeemed at any time for $25. You risk losing the $3.00 premium you paid for the bond if it is redeemed before the interest payments justify paying that premium. That’s why you don’t buy callable bonds (or preferred shares) above their call price if they can be immediately called.
A final risk is that interest rates will rise. In that case, you would still receive the same interest payments from your bond, but the value at which you could resell the bond will decline. This may not be an issue if you don’t plan to resell the bond, but a rise in interest rates can also reflect rising inflation. You may find some erosion of your buying power over time.
There are two major types of fixed income securities, as well as funds based on these securities.
The first type is bonds, which we have been discussing up to this point. The concept is straightforward. The issuer is borrowing money from you, and they pay you an interest rate that is correlated with the perceived credit risk.
You can buy a bond as a new issue or in the secondary market from your broker. You can also buy U.S. Treasury securities directly from the U.S. government at www.treasurydirect.gov.
The other type of fixed income security is preferred stock. Preferred stock is equity that normally has a fixed dividend payout. It has been called stock that behaves like a bond. Preferred stock, like common stock, represents a share of ownership in a company. But unlike common stock, preferred stock usually does not give shareholders voting rights.
If the company is liquidated, preferred stockholders have a greater claim to a company’s assets and earnings. Likewise, if a company misses a dividend payment, it must first pay back missed dividends to preferred shareholders before making payments to common shareholders. Further, the dividend is usually higher than for common stock.
The downside of preferred shares is there is limited growth potential compared to common shares. You give up long-term growth potential for better yields and more dividend security. But you will experience less volatility with the preferred stock. Also, like bonds, preferred stock may be callable.
That covers the most basic information about this class of securities. Given the current market uncertainty, you should really get up to speed on this investment option. Your retirement may depend on it.
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