Fixed Income Investments

Your retirement income investment plan starts now, right now, no matter how old or well heeled you happen to be.

Step One is to understand what a retirement plan is, and to identify the three large numbers you need to keep track of while you are developing your stash. With these three totals on your spreadsheet, it’s much easier to develop long-range retirement income goals that make personal sense. A retirement plan is an income production plan. Guaranteed retirement income – projected expenses = the gap. No gap, add parents and children to the expense number. There’s always a gap.

Employer provided pension plans, Social Security, and (always much too expensive) fixed annuity contracts, are retirement income providers. They are monthly income machines that you have paid dearly for but which may not be adequate to cover your retirement expenses— most of us will need more income than our guaranteed benefits will provide.

And we need to develop these additional income sources while we are still earning some kind of income. The retirement plan is the investment process you employ to eliminate the gap between your projected guaranteed income and a conservative estimate of your retirement expenses. The sooner and smarter you invest before retirement, the easier the transition from full employment to full vacation will be. Smart investing involves separating your security selections by purpose, and monitoring their performance in the same way. You’re never to young to start developing the income side of the portfolio.

Once you start to draw income at retirement, it is much more difficult to invest effectively and unemotionally. Since your income will need to remain secure and constant through several economic, market, and IRE (interest rate expectation) cycles, you really need to develop appropriate portfolio market value expectations if your program is to survive. You cannot afford to take your eye off the income ball, because income is the only thing you can spend without depleting the productive value of the assets in your investment portfolio.

Obvious? Yes, but only until the market value of your portfolio begins to shrink as a result of economic, market, and IRE cycles. If you invest properly, it (the income) should continue to grow in spite of changing market conditions and fluctuating market value numbers. You must learn to expect market value fluctuations and take advantage of them— assuming, of course, that you are following appropriate quality, diversification and income generation standards.

Retirement income planning became more difficult for most of us around the time corporate America realized that defined benefit pension plans were far too expensive to manage and maintain. At around the same time, the Social Security trust fund somehow disappeared (Did it ever exist at all?), and more and more of our hard earned was needed to support our aging friends and relatives. Why haven’t the myriad of defined contribution programs been able to fill the retirement income gap?

Because millions of totally investment-inexperienced people were given discretion over billions of investment dollars that could be tax detoured out of their paychecks and into IRAs, 401ks, 403bs, Thrift, Savings, Thrift/Savings Plans, etc. Self directed investment programs generated a need for an investment media; the investment media fueled the speculative juices of an emotional and naïve mass of newbie investor/speculators; Wall Street created tens of thousands of new products and compound income schemes to sponge up the wayward dollars.

The Masters of the Universe were ROTFLOL while the Investment gods gaped in disbelief.

Defined Contribution plans are just not retirement plans— even if your employee benefits department, the media, Wall Street, and Uncle assure you that they are. Most plans are difficult to self-manage with a retirement income objective. Still, these benefit plans are necessary and quite capable of taking you close to where you want to be. Their only drawback is the false sense of wealth and retirement security that they promote. Either the money has to be converted into an income portfolio— a costly and time-consuming process— or far too many mutual fund shares have to be sold to produce the spending money

Most people think of savings and investment programs as retirement plans, and rationalize away the need for additional, outside development of an income investment portfolio. This is because all of the information they receive speaks to market value growth instead of to income. It’s very likely that less than half the money will ever be yours to spend! What, you say— why? Here’s an example. A NYC resident with a $3 million IRA retires with the expectation of maintaining her life style. Even invested for income alone, $15,000 per month is easy to generate. But how much more has to be disbursed to satisfy three levels of tax collection?

Next example. The same portfolio in equity mutual funds during a correction— now your dipping into principal!

Even though defined-contribution plans are excellent mechanisms for growing an investment portfolio with your hard earned, pre-tax, dollars, most plans and most plan participants worship the market value god to the exclusion of all others. Most people are too greedy and/or tax-averse to convert them into income producers during rallies— when they can lock in a meaningful cash flow. Additionally, the counter productive IRC encourages our use of owned assets first— a universally ignored phenomenon.

The “buy and hold” mutual fund mentality doesn’t transition well from growth to income— regardless of the fund category or description; the idea of helping people into a comfortable retirement hasn’t stopped the tax collectors; the market cycle is just as likely to be down as up when your gold watch is presented. You have to do more, and less, to secure that comfortable retirement.

Step One of the retirement plan is developing a focus on income, and understanding that spending money and market value are not blood relatives. Step Two is developing the right combination of tax deferred and tax-exempt income— among other things.

Bonds – Turning Debt Into Fixed Income

Bonds are an often overlooked component of a balanced investment portfolio. Bonds are almost always safer, and in certain economic cycles, bonds typically outperform the stock market. Although they’re not right for everyone, a solid understanding of bonds is important for every serious investor.

The Basics

Whereas stocks represent ownership in a company, bonds represent the company’s debt. When you buy a bond directly from General Motors, you are essentially lending the company money. For this reason, bonds are sometimes referred to simply as “debt.”

If you buy a bond directly from its issuing company, the amount you pay for the bond is called its “face value” or “par value.” Most bonds have a face value of £1000.

Bonds also have a stated “term to maturity.” This could be one, five, ten, or thirty years, or any other duration imaginable. Disney actually issued 100 year bonds not long ago.

Every six months until maturity, bonds pay a set amount of interest called the “coupon rate”. This term comes from the old days when people literally tore off and mailed in coupons that were attached to their bonds in order to be sent back interest payments. Upon maturity, the issuers of bonds must repay their holders the face value of the bonds..

If, for example, the coupon rate is seven percent on a £1000 face value bond, this means that the bondholder will receive interest payments of £35 every six months (£70 per year) until the bond matures.

The amount of interest paid every six months doesn’t change, and for that reason bonds are sometimes called “fixed income securities.”

Corporate Debt

Corporate bonds are the best known, and riskiest of all bonds. If a company goes bankrupt, for example, its bondholders may receive a mere fraction of their investments. Credit rating agencies, such as S&P, assign ratings to fixed income securities ranging from AAA to D.

Bonds with credit ratings of BB and below are considered junk bonds, meaning that their issuing companies face a realistic possibility of defaulting on their debt.

Changes in a company’s credit rating effects the value of its debt. Although the face value always remains the same and the issuing company always redeems bonds at their original face value, bonds can also be traded between investors before they reach maturity.

These trades are said to take place on the “secondary market.” For example, if the credit rating of a company were lowered and you wanted to sell one of its bonds that you paid £1000 for, your fellow investors in the market may only be willing to pay you $950.

But what most commonly has an impact on a bond’s market value are changes in interest rates. Although the actual bond’s interest rate is fixed, prevailing interest rates elsewhere in the economy can radically alter the value of a bond.

If interest rates go up, the value of bonds go down, and vice versa. This is because no one would be willing to pay $1000 for a bond with a seven percent coupon when they could buy a new one with a nine percent coupon for the same price.

Government Debt

U.S. government bonds are the safest of all fixed income securities. This is because all government debt is backed by the full faith and credit of the U.S. government. Essentially, this means that the federal government can’t go bankrupt, because it controls the printing presses.

Municipal bonds are debt issued by cities and counties. They aren’t quite as safe as U.S. government securities, but they do have one major advantage – they are virtually exempt from all levels of taxation. As a result, municipal securities typically pay a lower pre-tax coupon rate than federal government debt.

For people in high income tax brackets, the tax savings are enough to offset the lower coupon rate, and thus municipal securities are often great investment vehicles for the wealthy.

If the volatility of the stock market makes you reach for the Pepto Bismol and you’ve decided that capital preservation is for you, then you’ve come to the right place. There are various instruments under this category and we’ll discuss some of these presently. Fixed income usually is in the form of Cd’s or bonds. In both cases you are lending money to a specific entity, with the promise that you’ll get paid back in full at a specific date in time.Yearly interest payments are made to you in the interim. The key to understanding bonds is that during the course of the time that you hold them, they will fluctuate in value depending on the current interest rate. In general, unless you trade bonds or are forced to sell one, you will not have to worry about values. When the bond matures you will get the face value of your investment back. Consequently when you buy a bond you may have to pay more or less of the face value of the bond, depending on the current interest rate. For example, a $10K bond giving 5% may cost you more if the current new bonds being offered are only 4%. Obviously 5% is better than 4%. So for this privilege you’ll pay a premium. On the other hand if you want to buy a 4% bond in a market that is offering 5% bonds, then a 10K bond may only cost you 9.5K. In either case checking with your broker or brokerage house and discussing strategies with them is advised. The following are various fixed income investments that are the most popular:

CD’S- loans made to banks. Keep investments under 95K to take advantage of the FDIC Insurance in case of bank insolvency.

Treasury bonds – Money lent to the government. The safest of all bonds. Backed by the government. They are federally taxable, but state tax exempt.

Municipal bonds – money lent to the states. Very safe if AAA rated and insured. Relatively expensive as bonds go. Federally tax free and state tax free if the bond is that of the state you live in. Exceptions to this are US territories and Puerto Rico bonds which are state tax free everywhere.

Corporate bonds – money lent to corporations. Fairly safe if AAA rate. No tax advantages, but have good interest rates.

Agencies and GinnieMaes – Federal bonds that deal with real estate. Agencies if AAA are very safe, relatively inexpensive, have good interest rates and some may be state tax exempt. They are all federally taxable.

Bond Mutual funds – mutual funds that invest in any of the above bonds. Good for people who don’t have large amounts of capital to invest and like liquidity. More prone to interest rate fluctuations than the actual bonds themselves. This is a good vehicle if you like risky bonds. You can have an entire basket of what is known as junk bonds with less risk than you would have if individually held. This can increase your interest earnings.

Whatever way you choose, either through individual bonds or mutual funds, fixed income opportunities abound and what you choose will be up to your particular specifications.

Bonds offer a stable-return for long-term investors. They are often referred to as “fixed-income” investments because they provide a stable rate of return (called yield) for investors.

Bonds are also the most common hedge against stock volatility, because stock market volatility will not affect bond prices. But it is a challenge for individual investors to benefit from bonds. Most bonds are offered in denominations of $1000 or higher, so an investor will need upwards of $50,000 to put together a well-diversified bond portfolio.

Enter fixed-income funds. Fixed-income funds offer small investors a way to invest smaller amounts into this essential asset class.

Risk

Investing in bonds carries two main risks: Credit Risk and Interest Rate Risk.

Credit Risk

Credit Risk is the risk that the bond’s value will decline because the credit rating of the issuer falls. Many bond investors holding auto manufacturer and airline bonds have experienced this in recent years.

Government bonds are typically immune to credit risk, but emerging markets bonds are an exception. In recent years Brazil and Argentina have defaulted on obligations. Currently, Iraq bonds are at a high risk of default.

Interest Rate Risk

Bond values fall when interest rates rise. While most everybody knows this rule, few understand how and why it works.

When current yields (interest rates) rise, then new bond issues are at a higher yield than old issues. So, a bond that’s six month’s old will lose value if interest rates have risen, since new bonds have a higher yield.

Conversely, if interest rates are falling, a bond issued six months ago will be worth more than its original purchase price, since current issues offer a higher yield.

Mutual Funds

Interest rate risk and credit risk and bond prices in general are highly specialized areas that most individuals don’t have the resources or the expertise to enter into. Furthermore, the various types of bonds issued (asset-backed, convertibles, munis, high-yield) make the bond market appear overwhelming. Fixed-income funds can offer the stable returns and expertise of experienced bond traders at a reasonable entry-level.

The best funds will allow the management to invest in a widely diversified Array of bonds. Management is best able to assess the market and determine which issues are likely to perform best.

Sometimes short-term low-yield Treasury securities will be the best fixed-income investment. At other times, long-term high-grade corporate notes will be favorably priced. In the 1980s and 1990s, high-yield junk bonds, issued by companies with low credit ratings, performed best.

For this reason, diversified bond funds work best for individual investors. Such funds will benefit from all possible issuers and types. The PIMCO Total Return Fund, PIMCO Diversified Income, and the Dodge and Cox Income Fund are excellent choices with reasonable expense ratios.

Municipal bond funds offer a tax-efficient income stream, as the returns from these funds are deductible from most state and local taxes.