While the “stock” or “equity” markets get a lot of media and investor attention, bonds and a variety of other fixed-income securities are often included in individual investors’ investment portfolios. Fixed-income securities are typically purchased by investors and their advisers to produce income and to mitigate overall portfolio risk. Three types of fixed-income securities are bonds, preferred stocks and commercial paper.

 

Bonds, in their simplest form, are loans – a promise to pay back the principal along with a set amount of interest over a specific period of time. For example, a state may sell a bond in order to raise money to build a new bridge, while a company may sell a bond to get cash to buy a factory. Bonds are generally considered less risky than stocks because they offer a consistent stream of interest payments and the return of the original loan amount at the bond’s maturity date. Less risk, however, does not equal no risk.  If the company who issued bonds to buy the factory goes bankrupt, then all of their bondholders might only get part of their original investment. Of course, if this were to happen, the company’s common stock shareholders might lose their entire investment.

 

Some bonds pay more interest than others because of two primary differences: the length to maturity and the perceived risk of default.  If we hold all other things equal, longer bond terms and/or more risk of default will equal higher interest. Let’s say that a government wants to issue some new, long-term bonds, but the country has already racked up a serious amount of debt and is spending more than it is collecting in taxes. In order to get investors to buy their new bonds, the government will need to offer a higher interest rate to investors for the perceived higher level of risk.

 

A very common way to get into bonds is through a bond mutual fund. To reduce risk and to boost performance, bond fund managers keep their portfolios well-diversified by holding hundreds of individual bonds in a variety of different categories such as: corporate bonds, high-yield bonds, treasury bonds, municipal bonds, foreign bonds, and short, intermediate, or long-term bonds. Even though bond funds are still affected by changes in interest rates and overall economic conditions, individual investors can reduce the risks associated with owning individual bonds and still get the potential benefits of the bond market.

Preferred Stocks fall right under stocks and right above bonds when it comes to risk, which might explain why they are called “preferred.” Unlike a bondholder, but like a common stockholder, investors in preferred stock have ownership in a corporation. Preferred shares commonly pay a dividend that is higher than that of common shares, but they don’t usually have the voting rights or the potential for appreciation of common stock shares. Another difference between preferred stock and common stock becomes apparent if a company runs short on cash and cannot meet all of its obligations. The company must first pay bondholders their interest, next preferred stock shareholders get their dividends, and then common stock shareholders get what’s left over. That means there can be times when a preferred stock shareholder won’t receive any dividends at all. That “extra” risk to the investor is what causes preferred stocks, in general, to generate more return than bonds.

 

Commercial Paper is a form of unsecured debt typically used by very large, publicly-traded companies to help them meet their short-term obligations and routine operating expenses. Because the maturity is usually for nine months or less, the companies don’t use the money to buy land, equipment, or buildings (bonds are for that). In other words, commercial paper is a formal IOU that big companies use to plug holes in their cash flows. Usually only companies with high credit ratings can issue their own commercial paper.

 

Generally, the interest paid by a company on commercial paper will be higher than what that same company pays on its bonds. Commercial paper is not considered as secure as bonds, so naturally, investors demand a higher return for the higher risk. Commercial paper is purchased at a discount, and the face amount is paid to the investor at maturity (including principal and interest). While it is outstanding, however, the value of commercial paper will fluctuate based on the strength of the issuing company and changes in interest rates, just like other fixed-income securities. 

 

Should fixed-income securities be in your investment portfolio? The short answer is “yes.” How much, of course, depends on your situation. For the 30-year period of 1981 through 2010, the S&P 500 index (dividends, gains, but no fees or taxes) had annual returns that swung as high as a 38% gain in 1995 and as low as a 37% loss in 2008. For the same period, annual returns for investment grade corporate bonds were as high as 33% in 1982, and the biggest loss was 3% in 1994 (interest and appreciation, but no fees or tax). Common sense would say that an investment portfolio built with both stocks and bonds ought to be less volatile than a portfolio made up entirely of stocks. For example, a 70/30 blend of bonds to stocks would have produced a smoother rider during that tumultuous 30-year period. Of course, the next thirty years may look absolutely nothing like the last thirty years, but the potential for bonds and other fixed-income securities to dampen the volatility of a stock portfolio is hard to ignore.

 

 

David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.