Question: My portfolio is a mix of what my advisor calls fixed income and stocks. What does fixed income mean?
Answer: Most investors divide liquid investments into three asset classes.
The first is cash, money market funds, checking accounts, and short-term CDs as cash equivalents. This asset class is most often used to store funds for short-term need (say less than two years), and the return on investment is usually a small loss when inflation is taken into account.
The second category of investments are global stocks (or equities), where you can hold (in funds and ETFs) actual shares of hundreds or thousands of companies around the world. Over the long term, equities as an asset class offer the highest “real” return after inflation, but with some upside and downside price volatility.
The third category of liquid investments would be the fixed income securities mentioned by your advisor. Fixed income securities generally refer to investments that lend money to various entities (banks, corporations, governments, etc.) in return for a promise to repay the money with interest over a set period of time. Although the asset class I mentioned above as cash and cash equivalents is technically fixed income, we consider longer term loans to be the fixed income asset class.
For example, a 10-year US Treasury bond can be purchased with $1,000. You loan the $1,000 to the US government and they promise to give you interest (currently) at the rate of 2.5% per annum for 10 years, then pay you back your initial $1,000. Since the bond is guaranteed by the full faith and credit of the US government, it is considered “safe”.
But is it? This is a certain losing investment due to inflation being higher than the current interest rate. If we assume that inflation is at least 6% at the moment, the 2.5% annual return does not keep up with the steady erosion of the purchasing power of the initial $1,000 in the future. After 10 years you’ve lost about 3.5% per year in purchasing power, then you’re given back $1,000 which can only buy what $650 bought the first year. To add insult to injury, you paid interest taxes every year, which probably compounded your absolute loss.
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Why would anyone own this “safe” fixed income? It belongs to families and institutions that need access to funds without volatility. For example, a retiree who takes regular distributions from his retirement savings would want to have enough fixed income to draw on during a downturn in stock prices. Additionally, a family that needs to use cash in a relatively short to medium time frame should use fixed income securities or cash to avoid the volatility of equity investments. A good example of this would be saving for a down payment on a house in a few years.
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Another factor to consider when investing in fixed income securities is credit risk, duration and changes in prevailing interest rates. The entities you lend money to have different levels of credit risk (the risk that they will repay you as promised). As noted, the US government is considered a major credit risk. Comparatively, a startup-backed bond carries a high risk that you won’t get your money back in full. Bonds with low credit risk normally pay higher interest rates to compensate. The length of the bond is called maturity or duration (I won’t discuss the difference here).
The longer you delay getting back all the promised money (both the interest and the return on your original investment at the end of the bond’s term), the higher your risk. A longer term introduces the risks of a change in the creditworthiness of the company, as well as the effects of variable inflation on the return on your investment.
For example, if you own a one-year bond and significant inflation occurs, you would only have to wait for your redemption in one year and reinvest at the new higher rate.
But if you own a 10-year bond and interest rates double in the first year you own the bond, you’re in trouble. You can either sit back and accept the interest rate that is below the new higher rate for another nine years. Or, you can sell the bond. But whoever buys it will pay you a lower price so that he captures the new higher interest rate.
There is so much more to consider with fixed income investments and many choices of ways to invest in this asset class. Ask about this if you manage your own portfolio or ask for help.
Steven Podnos is a paid financial planner in Central Florida. He can be contacted at [email protected] and at www.WealthCareLLC.com.