Investments

What Is Fixed Income 6

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 6 minute read

The stock market represents riches in the eyes of most people. Newcomers to the world of investing and trading are shown images of flashy vehicles, homes, yachts, and gorgeous people, all of which are within their reach if they only start investing and trading now.

Think instead of the story “The Hare and the Tortoise” by Aesop. The narrative encapsulates the human propensity to focus on the showy, confident, and charismatic while ignoring the reliable people who are always there for us.

The “hares” of the investment world are equity securities, which include stocks and other instruments that allow you to obtain equity ownership of underlying securities. They entice us with the prospect of easy money, promising a fast track to a life of luxury complete with flashy automobiles, attractive partners, and a mansion in the suburbs.

The hare’s life can be thrilling, but only if one has a strong stomach for the inevitable ups and downs and the frequent disconnects between promises and delivery.

Most investors would do better by making consistent investments in fixed-income securities (the “turtles” of Wall Street). American wealth is built on debt investments. Andrew Mellon, one of the wealthiest Americans of his day, is quoted as saying, Gentlemen prefer bonds.

Why You Should Own Fixed Income Securities

Although fixed-income investments are most popular among those who want a steady monthly income from their assets, they are nevertheless a good fit for almost every investment portfolio because of the following reasons:

1. Principal Safety

Does the bond market present a more secure alternative to the stock market? Unless the borrower defaults, bondholders are assured of receiving their principal plus interest when the bond matures, unlike stockholders who may or may not get any return on their investment.

The average global default rate for investment-grade bonds was 0.06% per year between 1981 and 2016, according to data compiled by Standard & Poor’s (S&P). At the same time, the average default rate for speculative bonds was around 5%.

As a result, at maturity, bondholders often receive a full return of their principal. There are times when keeping what you have is more important than making more money.

2. Stable Income

In good times and bad, bondholders can count on their fixed income. Timely and consistent payouts are guaranteed by a legal contract between the company issuing the bonds and the bondholders.

Some corporations pay dividends on a consistent basis, and many have done so for decades. However, the interest rate on investment-grade bonds is about twice as high as the dividend rate for the average company in the S&P 500 and is comparable to some high-dividend investments.

Based on the final equity price of the year, 82.6% of S&P 500 businesses distributed a dividend in 2017, with an average return of 1.87%, as reported by MarketWatch.

According to the Federal Reserve Bank of St. Louis, the average interest rate on Aaa-rated bonds (the highest grade of long-term bonds) was 3.51% throughout the same time frame. Lower-quality bond issuers pay higher interest rates.

3. A Less Volatile Market

Volatility describes the degree to which the price of an investment fluctuates over time relative to prior time periods. Since bond price fluctuations are linked to market interest rates rather than investor emotions, bonds have historically had much lower volatility than stocks.

Forbes reports that during the previous five years, the 30-day volatility of equities has averaged 12%, while the volatility of bonds has averaged 2.8%. Investment advisor Gregg Fisher of Gerstein Fisher explained this to the New York Times; You purchase bonds to lessen volatility, not to gain a return.

If you own bonds with lower volatility, you can continue investing in your long-term goals even when stock prices fall.

4. Recognized Return

Returns on equity investments are the dividends plus appreciation in value throughout the holding term, and neither of these outcomes is assured. The economic and societal climate, as well as investor confidence, have an indeterminate role in the pricing of common stock. 

That’s why it’s hard to predict the future performance of an equity investment and make plans based on it. A bond, on the other hand, is a contractual agreement between a lender and a borrower that specifies interest payment arrangements and outlines the lender’s and borrower’s respective rights and remedies in the case of a failure.

Additionally, upon maturity, bondholders have assured a return of principal or face value. That is to say, bondholders know exactly when and how much money they will get throughout the course of the bond’s existence, allowing them to save for things like retirement with confidence.

5. Liquidity

What makes an asset liquid is its convertibility to cash quickly and cheaply. The state of ultra-liquidity, or immediacy, occurs when there is a constant balance between buyers and sellers so that the vast majority of transactions have no impact on the price of the asset.

Since interest rate fluctuations are the only factor affecting the price of government and corporate bonds, they are considered highly liquid investments. In a recent interview with the New York Times, Allan Roth, founder of the Wealth Logic Advisory Firm, said, Bonds provide liquidity and courage when markets are sliding. 

The American Association of Individual Investors cautions, however, that not all bonds or bond markets are created equal, and that there are a wide variety of bond markets and bond investors.

6. The Tax Advantages

You won’t have to pay federal income tax on the interest you earn from municipal bonds (bonds issued by a state, city, or local government). Additionally, the income earned on municipal bonds issued in the owner’s home state is typically exempt from state and local taxes.

Additionally, investors with the highest tax rates can gain a great deal from purchasing municipal bonds. 

The Bond Buyer forecasts decreased volumes in municipal financings as a result of the abolition of advance refunding and the potential loss of state money due to lower property tax revenues, notwithstanding the preservation of the interest exemption following the adoption of the Tax Cuts and Jobs Act of 2017.

Bond prices and yields could go up if stable demand for municipal bonds is met by a smaller supply.

An Investment Portfolio Approach to Fixed Income

Experts in the financial sector agree that diversity and portfolio balance are the keys to long-term investment success:

  • The best long-term return may be found in an exceedingly risky equity portfolio. According to an article in The Atlantic, the value of 401(k)s and IRAs dropped by as much as 25%, losing $2.4 trillion. Many would-be retirees were instead compelled to delay their retirement or make significant cuts to their savings.
  • Avoiding market losses like the ones we saw in 2008 is a priority for many investors, but a portfolio made up entirely of fixed-income securities offers safety at the expense of performance. Over the three, five, and ten years ending on September 30, 2014, stocks significantly outperformed bonds, according to a study by The Balance. Morningstar’s Christine Benz estimates an 8-10% return on stocks and a 5-10% return on bonds over the next 20-30 years.

Age is often taken into account when deciding how to allocate fixed-income investments. If you’re 33 years old, for instance, you should put away 33% of your investment dollars in these safer options, freeing up 77% of your portfolio for higher-return assets such as classic stocks.

Your ability to take risks decreases with age because you have less time to bounce back from setbacks.

The bigger returns provided by investments in stocks must be balanced against the security provided by investments in bonds and other fixed-income instruments, so increasing your allocation to fixed-income investments as you age can help you achieve this.

Bottom Line

There are more than $92 trillion in bonds on the global bond market, which is far larger than the $70 trillion in stock investments in 2016. Approximately $30 billion in corporate bonds are traded daily in the United States, with average interest rates ranging from 3.66% on bonds rated Aaa by Moody’s to 4.71% on bonds rated Baa by Moody’s.

You shouldn’t have to choose between bonds and stocks; rather, you should be able to invest in both. In a perfect world, a diversified portfolio would include securities that would mitigate risk without materially lowering returns.

Analyze the moral of “The Lion and the Boar,” another Aesop fable, about the struggle between two animals over who would drink first from a well, when you consider the asset allocation for your portfolio. 

They came across a group of vultures who had been watching the fierce combat and were looking forward to a tasty meal. Given that neither could be sure of who would emerge victorious from the conflict, the two adversaries ultimately concluded that cooperating would be in their best interests.

The fixed-income market offers a wide variety of securities, issuers, maturities, conditions, and options to meet any investor’s requirements. Even if you’re not convinced that bonds should be part of your investment strategy, at least knowing that you have some will help you rest easier during downturn markets.

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