Investing in fixed income investments
As I promised in my last column, today we will talk about investing in fixed income investments. Fixed income investments include money market, bonds of all types and bond mutual funds. Even some dividend producing stocks may be considered in a fixed income portfolio. Also, international plays a part in the bond world, just as it does with stocks.
Money markets are mutual funds comprised of short term bonds. They are usually made up of bonds with a duration of less than one year, or the weighted average of the times until those fixed cash flows are received. In the past, money markets were considered safe havens for short term money. One could invest a dollar and be assured of receiving back the original dollar plus interest. Because of recent downturns in interest rates, money markets are less profitable as the current interest rate environment is very low, plus the money market has ongoing expense to pay, therefore the return is zero or less.
Bonds consist of many types and are generally considered safe. Bonds are rated by three main rating agencies: Moodys, Standard and Poors (S&P) and Fitch. They are rated AAA generally for US Treasuries all the way down to D for default with various other degrees in between. These agencies look at the financials of the entity issuing the bond; whether it is a government, municipality or corporation, to determine the ability of the bond issuer to repay the bond holders their principal along with the promised interest. When a bond is issued, covenants are placed on the issuing entity regarding the terms, just like when you go to a bank to get a loan, you must sign a loan agreement. The covenants are there to protect the bond holders. If a bond issuing entity does not live up to the covenants the rating agencies will lower the rating of the bond and possibly the bond will go into default. The bond holders can use the covenant provisions to collect the principal, just as the holder of a car loan can reposes your car if you do not make your car payments. This is important because the higher a bond is rated the less risk associated with it, which means it may sell for a higher price. But it also means the bond may have a lower coupon (or interest rate) associated with it. Therefore: a three year AAA rated government bond may have a coupon rate of 3% while at the same time a company with a B rating three year bond coupon rate may be 4%. But you might not want to buy the higher coupon because the company issuing the bond is riskier.
If all this sounds confusing, it is. And it gets more complicated as we figure in the cost of the bond. Bonds are issued in $1,000 increments. Each $1,000 increment is considered par. If a bond is of high quality and was issued with a higher coupon rate than what is currently being issued, the bond will sell for more than par, which is called premium . So, for example, you may pay $1,010 dollars for the bond. When the bond matures you will receive $1,000 back as principal. The interest you receive in the meantime will be the stated coupon rate of the bond. The opposite is true if one buys a bond at a discount. That means the price one pays for the bond is less than par and generally the interest rate is lower than the current rates.
As you can see, the factors involved with buying bonds to create a fixed income portfolio are many. In later columns I will discuss how you can use bond mutual funds and dividend paying stocks and how they may play a part in your portfolios.
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