Understanding income investing: valid expectations, Pt. 1
By Steve Selengut
I've come to the conclusion that the stock market is an easier medium for investors to understand — to form behavioral expectations about — than the fixed income market. As unlikely as this sounds, experience proves it, irrefutably. Few investors grow to love volatility as I do, but most expect it in the market value of their equity positions.
When dealing with income purpose securities however, neither investors nor their advisers are comfortable with any downward movement at all. Most won't consider taking profits when prices increase, but will rush in to accept losses when prices fall.
Here are the important characteristics of income securities:
1. They are negotiable securities that generate a relatively stable stream of interest or dividend income, and include bonds, income CEFs, preferred shares, unit trusts, federal and municipal issues, income real estate, etc.
2. They, or the securities they hold, normally have specific payment dates and amounts.
3. Income securities are issued by governments or corporations, and have a maturity date when the issuer plans to repay all remaining principal and any unpaid interest.
4. Risk will vary, depending on the type, quality and maturity of the security, but income securities are considered far less risky than equities.
5. They fluctuate in market price, and mostly as a function of changes in interest rate expectations (IRE).
Still, Wall Street pumps out products and investment experts rationalize strategies that cloud the simple rules governing the behavior of what should be an investor's retirement blanket. I constantly shake my head in disbelief. The investment gods have spoken: "The market price of income securities absolutely shall vary inversely with interest rates, both actual and anticipated — and it is good."
It's OK, it's natural and it just doesn't really matter. You have to understand how these securities react to interest rate expectations and take advantage of it. There's no need to hedge against it or to cry about it. It's simply the nature of things. There are several reasons why investors have invalid expectations about their income investments:
- They don't experience this type of investing until retirement planning time and they view all securities with an eye on market value, as they have been programmed to do by Wall Street.
- The combination of increasing age and inexperience creates an inordinate fear of loss that is preyed upon by commissioned sales persons.
- They have trouble distinguishing between the income generating purpose of income securities and the fact that they are negotiable instruments whose market value is a function of current, as opposed to contractual, interest rates.
- They have been brainwashed into believing that the market value of their portfolio, and not the income that it generates, is their primary weapon against inflation.
Every properly constructed portfolio will contain securities whose primary purpose is to generate income (fixed and/or variable), and every investor must understand some basic and absolute characteristics of interest rate sensitive securities.
These securities include corporate, government, and municipal bonds, preferred stocks, many closed end funds, unit trusts, REITs, royalty trusts, treasury securities, etc. Most are legally binding contracts between the owner of the securities (you, or an investment company that you own a piece of) and an entity that promises to pay a fixed rate of interest for the use of the money.
They are primary debts of the issuer, and must be paid before all other obligations. They are negotiable, meaning they can be bought and sold, at a price that varies with current interest rates. The longer the duration of the obligation, the more price fluctuation cycles will occur during the holding period. Typically, longer obligation securities also have higher interest rates. Two things are accomplished by buying shorter duration securities: you earn less interest and you pay your broker a commission more frequently.
Defaults in interest payments are extremely rare, particularly in investment grade securities, and it is very likely that you will receive a predictable, constant and gradually increasing flow of income. The income will increase gradually only if you manage your asset allocation properly by adding proportionately to your income purpose holdings.
So, if everything is going according to plan, all that you ever need to look at is the amount of income your income portfolio is generating — period. Head for the golf course.
Dealing with variable income securities is slightly different, as market value will also vary with the nature of the income and the economics of a particular industry. REITs, royalty trusts, unit trusts, and even closed end funds (CEFs may have variable income levels, and portfolio management requires an understanding of the risks involved.
A municipal bond CEF, for example will have a much more dependable cash flow and considerably more price stability than an oil and gas royalty trust. Thus, diversification in the income-generating portion of the portfolio is even more important than in the growth portion — income pays the bills. Never lose sight of that fact and you will be able to go sky diving more frequently in retirement.