Fixed-Income Securities: Risk, Interest and Return
There are a variety of fixed-income securities available in the marketplace. Each type has its advantages which could make it an appropriate holding in a well-diversified portfolio. But there are risks and disadvantages that should be considered. Fixed-income securities commonly held by retail investors include:
Preferred Stock is partial ownership in a publicly-traded (and sometimes private) company. Investors receive a set rate of return instead of the greater upside potential of regular company stock. It is relatively easy to buy and sell on the open market. Company financial strength and ratings, interest rates, risk of being redeemed and merger/acquisition activity can all affect the value. The interest rate (referred to as a “dividend”) is usually set when the stock is issued; under certain financial situations, however, the company may have the option of reducing, delaying or even skipping dividend payments.
REITs (Real Estate Investment Trusts) may be publicly-traded or privately-held and hold income-producing real estate, like shopping malls, offices and restaurants. Both are relatively easy to buy, but the private version is often harder to sell. The quality of the real estate portfolio, occupancy rates and consistency of investor distributions, can affect the value of a REIT. The investor’s “payout rate” may be projected at the time of purchase, but dividends depend on profits.
Bonds are formal contracts for a fixed interest rate and loan period. The risk of being redeemed early, interest rate changes and company financial strength can affect the value of bonds. Most individual bonds are relatively easy to buy and sell.
When it comes to fixed-income securities, investors can get into trouble when they seek gains without looking at the whole investment. The total return of a bond, for example, is not the same as its interest. Interest is the payment you receive for the money you loan to someone else. Total return is the interest you receive plus or minus the fluctuation of the bond’s principal (what you invested). If you earn interest, but lose some of your principal, your actual return can be less than the interest. For example, if you earn 7% interest on a bond in a year, but the bond’s price drops 11% over the same period, what did you really make? This isn’t a trick question. The interest would be 7%, but your net return would be negative 4%. Two of the risks that can cause your total return to be less than your interest are “interest rate risk” and “default risk.”
Interest Rate Risk: Buying a thirty-year bond when prevailing interest rates are low is an example of not looking at the whole investment; bonds will very likely go down in value when interest rates start moving up. Yes, a thirty-year bond will pay more than a shorter term alternative, but an individual investor would likely take a large loss if he tried to sell that long-term bond in favor of another investment (especially after rates had already moved up). When the Federal Reserve raises interest rates to help rein in inflation, new debt starts getting issued at higher rates. At the same time, existing publicly-traded debt also gets “re-priced” by buyers and sellers in the market. Let’s say you own a $50,000 ten-year bond paying 4%. If interest rates increase by 1%, your bond will get “re-priced” by the market so that it might only be worth $45,000. As interest rates continue to rise, your bond could fall further in value. Investors would prefer to buy a “newer” bond that pays more interest than yours does. This means your bond would have to be cheaper to produce the same return as the “newer” bond. Morningstar Research did a study and found that whenever interest rates increased by 1%, 10-year bonds decreased by about 10%. Of course, if interest rates go down, the opposite change in value could occur; your bond would be worth more! If you hold your bond to maturity and the company is in good financial shape, you will get the full face value regardless of interest rate changes.
Default Risk: The allure of high yield bonds can cause investors to overlook their risks. Yes, these “junk” bonds usually pay higher interest, but there is a reason for that: more risk of loss. When a bond “defaults,” that means the issuer has stopped paying the semi-annual interest payments to bondholders. It could even become worthless. What good is 9% interest on a junk bond if you never get your original investment back?
Carefully consider the overall economic environment and your individual situation before investing. If you choose bonds and other fixed-income securities, be sure to weigh the interest to be earned against the potential loss of investment value. Check out financial ratings with firms like Standard & Poor’s and Moody’s. Also, don’t forget to diversify and monitor your fixed-income securities just as you would a stock portfolio.
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.