Fixed-Income Tactics: Your Best Defense

Fixed-income investments pay a constant rate of return to an investor. Despite the name, fixed-income investing is not synonymous with no-risk investing; nor do fixed-income investments protect an investor in times of rising inflation. Still, they are an important part of a well-rounded investment portfolio.

"Fixed-income investments bring diversification to a portfolio," explains Walt Woerheide, PhD, vice president and professor of investments at the American College. "When you add fixed-income investments, although you're reducing your expected return, you're usually taking quite a chunk out of the variability of the return. For anyone who has a reasonable degree of risk aversion, it's a very integral element of a portfolio."

Inflation & Risk

Inflation is the enemy of fixed-income investors. According to MyCFO.com, from 1940 to 1979, fixed-income investors suffered negative real (ie, after inflation) rates of return. That's 40 years of negative real returns, a detriment to any investor's portfolio. A careful analysis of real return is important when considering a fixed-income investment.

For example, CDs have long been considered a stable and safe form of fixed investments. But as Michael Shustek, CEO of Vestin Group (212-508-9641), points out, you have to take the inflation factor into consideration.

"The other day I noticed that 1-year CDs were paying 1.8%," Shustek explains. "By the time you pay income tax on that return—if you're a doctor that's around 40%—you're down to a 1% return. Factor in inflation at 2% or 3%, and you're going backwards."

Of course, with the lower rate of return currently offered by CDs comes a reduction in risk, which is an important element in any fixed-income investment. The balancing act then becomes a question of how much risk vs how much return investors want.

"I remember seeing a rule of thumb that the percentage of your portfolio in fixed-return investments should be about equal to your age," Woerheide says. "However, that can be an overly conservative approach." Woerheide points out that his 85-year-old mother has stocks in her portfolio because they can provide a tremendous inflation hedge. "Just as bonds provide diversification from stocks, stocks provide important diversification from bonds."

When interest rates go up, most fixed-income investments take a hit, whereas stocks generally do not. And at present, interest rates have almost nowhere to go but up. So while it's true that, in general, the older you get the more you should think about fixed returns, Woerheide cautions that if fixed-income investments make up more than 70% of your portfolio, you're being too conservative. "If you're fortunate enough to be 75-years-old and live another 15 years, without stocks in your portfolio, you could be in trouble when you reach your late 80s."

Shustek disagrees, but only in terms of the breakdown of stocks and fixed-income investments. The reason, Shustek says, is to protect the assets you've accumulated because the ability to continue earning a large income after age 50 gradually diminishes. "If you're a younger doctor, fixed-income investments still need to be about 15% of your portfolio, with the remainder in stocks and bonds," Shustek explains. "As you get older, that pie should get smaller, and by the time you reach age 50, it should be down to around 25% in stocks and bonds."

Corporate & Municipal Bonds

A corporate bond, which is issued by a corporation, is 1 form of fixed-income investments. These bonds are taxable, have term maturity, are paid for out of a fund accumulated for that purpose, and are traded on major exchanges. Generally, these bonds pay higher rates than government or municipal bonds, but the risk is also higher. Corporate bonds have a wide range of ratings and yields because the financial health of the issuers can vary widely—something you need to consider if you choose them.

A municipal bond, which is issued by the state, city, or local government, is another form of fixed-income investments. Municipalities issue bonds to raise capital for their day-to-day activities and for specific projects, such as roads, sewage systems, hospitals, etc. Interest on municipal bonds is generally exempt from federal tax.

"With a municipal bond, you're investing in something that is tax-free, so you're meeting 1 of the factors that contribute to real purchasing power," Shustek says. "At the end of the day, if you're getting 2% or 3% on a municipal bond, at least it's a true 2% and you're staying even with inflation."

Woerheide suggests that for individual investors, the safer, more prudent fixed-income investment might be a bond mutual fund. These bond funds invest in municipal bonds. They are popular among investors in high income tax brackets because they are exempt from federal taxes and, in some cases, from state taxes as well. As with US government bond funds, the underlying securities in municipal bond funds are backed by the government and are considered to have a high credit rating.

"The nice thing about bond mutual funds, particularly no-load bond mutual funds, is you can basically get in them without having to pay commissions," Woerheide explains. "All mutual funds have a management fee associated with them. Bond mutual fund management fees tend to run lower than stock mutual fund management fees. So, if an investor tends to hold a portfolio for just a couple of years and wants to be sure of quality and time diversification, a no-load bond mutual fund makes a lot of sense."

Mortgage-Backed Securities

Mortgage-backed securities (also known as mortgage-backed certificates) are securities that are backed by a pool of mortgages, such as those issued by Ginnie Mae and Freddie Mac. A security is created when a group of mortgages are gathered together and bonds are sold to other institutions or the public. Investors receive a portion of the interest payments on the mortgages as well as the principal payments, which are usually guaranteed by the government. However, some experts are not enamored with them.

"Mortgage-backed securities have a couple of problems," Woerheide says. "If interest rates are high, they look terrific, because you get a great rate of return. But if interest rates start falling, people start prepaying on those mortgages and refi- nancing. Then those great rates of return go away." Conversely, if interest rates are low when you purchase a mortgage-backed security and then they start to rise, people will think twice about refinancing or paying off their mortgage.

Lois Fishman, CFP®, Fishman Financial Services (301-330-9455; www.fishmanfinancial.com), further accentuates the problem with mortgage-backed securities. She points out that while interest rates move up, signaling a better rate of return interest-wise, the asset value of fixed-income investments goes down. She notes that for every 1% rise in interest, an investment could drop 10% in value.

"If you're in mortgage-backed securities strictly for the income, then it won't matter that much," Fishman explains. "But if you're in it for the growth, then it does matter. So you need to be very much aware of why you're investing in them."

Shustek, a big supporter of mortgage-backed securities, acknowledges that investing in mortgage-backed securities is not like seeing a stock triple in a year; it's more slow and steady. "As long as you're dealing with a reputable company, mortgage-backed securities are 1 of the safest ways to diversify your portfolio."

Certificates of Deposit

CDs are fixed-income investment vehicles usually issued by banks and other financial institutions that pay a fixed rate of interest for a specific period of time. Most CDs, but not all, are FDIC-insured up to $100,000 per customer. So as long as you purchase a CD that is FDIC-insured, you have a Treasury-quality investment.

One of the downsides to CDs in the current market is their low interest rate. However, according to John Armstead, a registered principal of Protected Investors of America (800-786-2559; www.protectedinvestors1934.com), that's a relative statement.

"Relative to a US Treasury of the same maturity, you can probably find a higher yield with a CD," he explains. "You can't just say that they're not good investments because interest rates are very low right now, because you might have need for a 1- or 2-year CD. So I don't think you should throw out the entire class."

There are plenty of CDs to choose from. For example, there are CDs linked to the S&P 500 and the Nasdaq. However, Armstead cautions against these types of CDs because they contain a performance cap that limits the appreciation potential. So even if the S&P 500 and Nasdaq do well, your CD's performance will be limited.

Some long-term, high-yield CDs have "call" features. This means that the issuing bank may choose to terminate, or call, the CD prior to its date of maturity. For example, a bank might decide to call its high-yield CDs if interest rates dropped significantly. In contrast, however, if you invest in a long-term CD and interest rates rise substantially, you will still be locked in at the lower, original rate.

In addition, while most investors have traditionally purchased their CDs through local banks, many brokerage firms and independent salespeople are now offering CDs. And the CD product itself has become more complicated, enabling investors to choose from a wider range of CDs, but requiring that you understand all the different terms before making the purchase.