Expectations for Assessing Fixed Income Securities

Expectations for Assessing Fixed Income Securities

My research has led me to believe that the stock market is far simpler for investors to comprehend (in the sense of being able to create behavioral expectations) than the fixed income market. Even though it seems implausible, actual practice has shown that it is so. Although I have come to enjoy volatility in my portfolio's market value, most investors do not share my sentiment. However, neither they nor their advisors are happy about the prospect of a decline in the value of their fixed income securities. When prices rise, most people won't think about cashing out, but they'll jump at the chance to take a loss when they drop.

Fixed-income securities, whose primary function is to provide income and whose return of principal is often a contractual obligation, are, in theory, the ideal buy-and-hold investment. As a means of spicing up an otherwise monotonous diet, I prefer to cash in on opportunities to make a profit, but I try to avoid serving myself losses until they are absolutely essential. 

However, Wall Street continues to produce products, and investment experts continue to justify techniques that obfuscate the simple laws controlling the behavior of what should be an investor's retirement security blanket. There are countless times throughout the day when I shake my head in astonishment. The financial gods have spoken, and they say, "The market price of fixed income securities shall move inversely with interest rates, both current and predicted... and it is excellent."

Everyone should just chill out because it's normal and it doesn't really matter, I tell the skeptics. To profit from the correlation between interest rate expectations and the performance of these assets, you must first understand how they behave in response to those expectations. Avoiding it or moping over it is unnecessary. This is how the world works; accept it. In the next three weeks, I'll be publishing a series of articles on fixed income investing, of which this is the first. If I haven't succeeded in making you feel more at ease with this attempt, perhaps the next will.

Investors' expectations of fixed income investments are often incorrect for a number of reasons: (1) They don't start investing until they're preparing for retirement, and by then they've been brainwashed by Wall Street to evaluate stocks based on their market value. (2) Commissioned salespeople of every stripe pray on the irrational dread of loss that comes with advancing age and lack of life experience. Thirdly, they can't tell the difference between the fact that fixed-income securities are meant to provide income and the fact that they are negotiable instruments whose market value is determined by prevailing interest rates rather than those specified in any underlying contracts. (4) They've been led to believe that their principal defense against inflation is the market value of their portfolio, rather than the income it delivers. You wouldn't feel any loss, worry, or urgency to make a change if you kept these stocks in a safe deposit box instead of a brokerage account and collected the interest payments instead. Give it some thought.

It is important for every investor to have a firm grasp on the fundamental and "absolute" characteristics of interest rate-sensitive assets, as every well-balanced portfolio will include securities whose primary goal is to provide income (fixed and/or variable). All types of bonds (corporate, government, and municipal), preferred stocks, closed-end funds, unit trusts, real estate investment trusts, royalty trusts, and treasury securities, among others, fall under this category. 

The vast majority of securities are legally binding agreements between the owner of the securities (you or the investment company in which you have an ownership stake) and the company, which promises to pay a fixed rate of interest for the use of the money. They have priority over all other debts owed by the issuer and must be repaid in full before anything else. They can be purchased and sold at a market price that varies with interest rates and are thus negotiable.The greater the time frame during which an obligation must be held, the greater the frequency with which price fluctuations will occur. Interest rates tend to be higher on longer-term commitments. By buying shorter-term securities, you get less interest and pay your broker a commission more frequently.

Defaults in interest payments are relatively unusual, particularly in investment-grade securities, and it is very likely that you will receive a predictable, steady, and steadily growing flow of income. (Only if you maintain a balanced asset allocation and add to your fixed income holdings in proportion will your income grow over time.) As a result, if everything is running smoothly, you only need to worry about one thing: how much money is coming in from your fixed income investments. In the case of variable income securities, however, things are a little different because the market value will also change depending on the source of the income and the state of the economy. 

Understanding the risks involved is essential for portfolio management when dealing with real estate investment trusts, royalty trusts, unit trusts, or closed-end funds (CEFs). A municipal bond CEF, for example, will have a significantly more consistent revenue flow and considerably more price stability than an oil and gas royalty trust. Therefore, it is much more crucial to diversify the income-generating half of the portfolio than the growth portion... Money pays the bills. Keeping that in mind will allow you to enjoy retirement fishing more often.

To understand the significance of the connection between your portfolio's two types of securities, you must first understand that your fixed-income investments' market value has zero bearing on the value of your equity investments. Each market dances to its own beat. 

The stock market is as unpredictable as hard metal or rap. Bonds are far more predictable, akin to the old school of rock and roll or the classics. That's why it's crucial for portfolio happiness's sake to learn to emotionally, if not physically, partition the two types of assets. If your market value decreased in July 2005, for instance, it was likely due to changes in interest rates rather than a drop in stock prices. Recently, increasing interest rates and a declining stock market have been a double whammy for portfolio market values but a double boon for investing prospects. Similarly, like shopping at a mall, a decrease in the price of a security is helpful for those looking to purchase it, while an increase in price benefits those looking to sell it. These things require action at each cyclical shift.

To avoid unpleasant surprises while dealing with fixed income market values, try this straightforward method. Imagine, blindfolded or not, the Scales of Justice. Your fixed-income portfolio's CMV (current market value) is listed on one side. In contrast, we have a little I for interest rates and "up" or "down" arrows for the expected direction of interest rates. The current situation, in which the world anticipates that interest rates will rise or at least cease falling, is shown by the addition of "up" arrows to the letter I while the Market Value column continues its downward trend. In this case, there is nothing that can (or even should) be done. Neither the maturity value nor the cash flow of the contracts you hold are impacted in any way by this. On the other hand, your broker just called with a suggestion.

Also, the mechanics are straightforward. money market instruments with a predetermined interest rate. The only way to satisfy the demand for up-to-date interest rates from purchasers is to provide an existing security at a discount. Thankfully, selling is a necessity that rarely arises. Because interest rates have been lowered in recent years, the value of fixed-income assets has increased, and their owners (should have) realized capital gains, boosting their portfolio's earnings and freeing up cash for other purposes.Now is a good time to add to existing holdings or purchase new assets because the trend has reversed and you may do so at cheaper prices and greater interest rates. This loop will go on indefinitely.

Therefore, it is crucial that you comprehend changes in market value, anticipate them, and embrace the opportunities that they give from the perspective of "let's try to be happy with our investment portfolio since it's financially healthier." Valuing your portfolio based on a metric that doesn't pertain to it (market value) is pointless. In fact, you may find yourself in a particularly advantageous position if you hold your fixed-income securities in the most freely negotiable manner possible. If security prices drop, you can buy more of them at a lower cost and increase your yield. It's almost like magic, or maybe it's just fairness. As the investment gods intended, both sides of the scale offer positive news for the investor.