Understanding income investing — valid expectations, Pt. 2

By Steve Selengut

The critical relationship between the two classes of securities in your portfolio is this: The market value of your equity investments and that of your fixed income investments are totally and completely unrelated. Each market dances to its own beat. Stocks are like heavy metal or rap — impossible to predict. Bonds are more like the classics and old time rock-and-roll — much more predictable.

Thus, for the sake of portfolio smile maintenance, you must develop the ability to separate the two classes of securities mentally, if not physically. For example, if your July 2005 market value fell, it was because of higher interest rates, not lower stock prices. More recently, the combination of higher rates and a weaker stock market has been a double whammy for portfolio market values, and a double bonanza for investment opportunities.

Just like at the mall, lower securities prices are a good thing for buyers, and higher prices are a good thing for sellers. You need to act on these things with each cyclical change; you must be willing and able to wear both hats simultaneously.

Here's a simple way to deal with income security market values to avoid shocks and surprises. Just visualize the scales of justice, with or without the blindfold. On one side, we have a number that represents the current value of your income portfolio. On the other side, we have a small "i" for interest rates, and up or down arrows that represent interest rate directional expectations.

If the world expects interest rates to rise, or even to stop going down, up arrows are added to "i" and the market value side moves lower — the current scenario (and the scenario when this article was first published). Absolutely nothing can (or should) be done about it. It has no impact at all on the contracts you hold or the interest that you will receive. Neither the maturity value nor the cash flow is affected — but your broker just called with an idea.

The mechanics are also simple. These are negotiable securities carrying a fixed interest rate. Buyers are entitled to current rates, and the only way to provide them on an existing security is to sell it at a discount. Fortunately, one rarely has to sell.
Over the past few years of falling interest rates, income securities have risen in price and investors (should) have realized capital gains as a result — adding to portfolio income and to working capital. Now that trend has reversed itself and you have the opportunity to add to existing holdings, or to buy new securities, at lower prices and higher interest rates. This cycle will be repeated forever.

So, from a "let's try to be happy with our investment portfolio because it's financially and emotionally healthier" standpoint, it is critical that you understand changes in market value, anticipate them, and appreciate the opportunities that they provide.

Comparing your portfolio market value with some external and unrelated number accomplishes nothing. Actually, owning your fixed income securities in the most freely negotiable manner possible can put you in a unique position. You have no increased risk from a reduction in security prices, while you gain the ability to add to holdings at higher yields.

It's like magic, or is it justice? Both sides of the scales contain good news for the investor — as the investment gods intended.