The Principles of Fixed Income Investing

PART FOUR: Managing the Fixed Income Portfolio

• What's better for your financial health: receiving 2% or 7%?
  
• The media is (unintentionally) doing all that it can to confuse people about the simple (and obvious) answer to this basic investment question. The problem lies in the fact that investment commentary is given totally outside, and without consideration of, Personal Asset Allocation Models. Such a model invariably and correctly has a target percentage for investments in various types of fixed income securities, and the income portion of the portfolio is added to at all times regardless of current interest rate levels. This is a form of "compounding", something we don't hear too much about anymore.
  
• Anything less disciplined is merely speculation as to the direction of future rates and is always counter productive. Still, it is what financial experts love to do! Why? Because, for some reason, they think of income investing as a boring alternative to equity speculating and not as an integral part of a long term investment plan. A place to "park the money" until the time is "right" to buy stocks again! Consequently, they are cautioning the public that buying bond (funds) now (for higher income than money market funds and less risk than stocks) may not be a good idea because interest rates may have the audacity to go back up, reducing the market value of the funds!
  
• So, you say, that's absolutely true! And, I agree that the market value of any fixed income security will fall with expectations of increasing interest rates. BUT, the point is that the PURPOSE of income securities is to generate income and not to produce some meaningless rise in market value. Why meaningless? Because the average investor would never even consider taking a trading profit on a bond type security. 
  
• Another problem with popular advice in the fixed income arena is the premise that investors' only available fixed income investment vehicle is the conventional (open ended) bond fund. Bond funds are the worst possible income vehicle out there for many of the same reasons that equity funds disappoint people on a regular basis. Preferred Stocks, Corporate Bond Unit Trusts, Closed End Municipal Funds, some REITs, and Government Securities can all be purchased by individuals for consistent and predictable cash flow. If interest rates fall further, profit taking opportunities may occur. At lower rates, just buy more of those securities that return principal regularly. As interest rates rise, it's easy to add to holdings selectively to increase yield and to reduce average cost. Unrealized growth (or loss) of market value must not be an issue. The purpose of this type of investment is income and only income. A realized gain is gravy. A realized loss, unnecessary.
  
• And then there's the question of purchasing high yielding stocks, as a substitute for fixed income investing itself. Not the right thinking at all. Is 4% better than 7%? Same answer as above. Equities are equities and should never be used as a fixed income allocation "filler". If the high dividend yield means that a good quality stock is undervalued, by all means add it to your equity holdings (and don't forget to sell it when it goes up a reasonable amount). I, for one, would never buy a stock that didn't pay some dividend... but why? Not for the obvious reasons for sure.
  
• In my 30 years of managing money, I have seen more errors in judgment in the fixed income area than anywhere else, particularly in those historically rare circumstances where rates move quickly in either direction! There are just two classes of investment securities and each has a distinctly different purpose. Never lose sight of that and you will avoid many costly mistakes.

PART FIVE: Asset Allocation Considerations & the Fixed Income Portfolio

Income is the only consideration, safe and predictable.

Similarly, the movement of a person's assets from a falling bond market to a rising stock market or vice versa is about as far away from the principles of asset allocation as one can get!

Note: If you focus exclusively on "market value", dwell upon comparisons of a unique portfolio with Market Averages, expect "performance" during specific time intervals, and listen intently when someone speaks about the future, any asset allocation work you do will be ineffective.

Part Six: Links to Fixed Income Security Information Web Sites

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