Broker Check

Approaches to Fixed Income

June 27, 2018

When it comes to investing, I believe in diversification. Sure, when the bulls are running and the stock market is strong, many people seem to believe the answer to all investing questions is buying equities. If only life were that simple.

It seems when things are going well in the stock market, we forget the times that things seemed downright calamitous. Think of the crisis back in September 2008 and the Great Recession. The market lost more than half its value in a short amount of time. Now, some people will be quick to point out that the stock market came back and then some. That is true. However, what if you had needed some of the money you invested in the stock market when it crashed?

You see, diversification is a methodology – not foolproof by any means – that helps to protect us from precipitous declines in a given asset class. By not having all our eggs in one basket, the idea is that if one of those baskets falls, not all our eggs will be destroyed. That makes good sense.

The difficulty we have faced over the last number of years is that interest rates have been so anemic that creating balance in an investment portfolio might not have looked appealing. If we use the S&P 500 index as an indicator of how the stock market has performed over the last nine years, it becomes clear that values have been on an upward trajectory. During that same period of time, interest rates have languished, relatively speaking, making many options in fixed income seem unappealing.

And yet, diversification is important.

If you accept that diversification is important, yet you want to maximize the performance of your investment portfolio, what are you to do?
For example, imagine that you are a 50 year old with a $1,000,000 portfolio. You follow the guideline of diversifying among asset classes based on your age. Using the formula of 100 minus your age, you wish to invest 50% of your money in fixed income. Essentially, half in stocks and half in fixed income.

What should you put the money earmarked for fixed income into?

With the possibility of interest rates rising, you might not want to lock your money into a given vehicle for a long period of time. Hey, how about putting some money into a three month CD? As of this writing, what might you earn over that period of time? Probably around 2%. How about some AAA rated corporate bonds? Surprisingly, probably around the same. That does not seem particularly attractive. At least the CDs are typically FDIC insured.

What if you went into junk bonds, bonds that are high risk in nature? Well, first of all, going into junk bonds seems to defeat the purpose of going into fixed income to begin with, which is to create stability and decrease risk. And what could you earn anyway, for some junk that matures in about a year? Probably around 3.5%. Not attractive considering the risk.

Oh, you say, we can go into municipal bonds. Okay, I am game. What might we earn? Perhaps, around 2% if we have a one year maturity. Again, not particularly compelling. And yet, as mentioned before, to have a properly diversified portfolio, we should, by all telling, have a fixed income component.

What if I told you that there was a financial vehicle – a savings plan – that could stand in the shoes of fixed income and, perhaps, meet a good portion of your fixed income needs while being dynamic at the same time. By dynamic I mean that based on history – which of course does not necessarily predict a future outcome – this vehicle has been interest rate responsive. Meaning that when interest rates have risen, so has the effective yield on this vehicle.

Now contrast that with the danger posed by owning bonds. When interest rates (yields) go up, bond values decline, sometimes sharply, depending on how much and how quickly interest rates rise.

This makes perfect sense. If I own a bond paying 2% interest and someone can buy a similar bond paying 3%, who in their right mind would choose 2%? So, the way the market incentivizes someone to accept an inferior interest rate is by discounting the purchase price of my 2% bond. This can lead to significant losses.

“Hold on there a minute”, some might say. I’ll just hold the bond to maturity (assuming the company remains solvent) and collect my full principal! You can certainly do that. Yet there might still be a subtle but sharp a cost to you and yours.

In fact, there is even a name for it, it is known as opportunity cost. Opportunity cost in this example is the money you would have made if you were invested in higher yielding bonds over the same period. On $500,000, a 1% per annum lost opportunity cost would total $50,000 after ten years. As we used to say in Bayonne, where I grew up, that’s not chump change!

Oh, and there are other powerful benefits to this kind of a plan.

Sound intriguing?

You might want to research this or speak with a financial services professional to find out more.

Remember, life presents challenges. However, life also provides options to surmount those challenges and prevail. Opportunities exist and the options we choose can have far reaching implications. It is up us to search out those opportunities, learn about them and ultimately, to take action.


Scott R. McGimpsey June 27th, 2018

This material was prepared by Scott McGimpsey and does not necessarily represent the views of the presenting party, nor their affiliates. All information is believed to be from reliable sources, however, we make no representation as to its completeness or accuracy. Neither Summit Brokerage Services Inc. nor Scott McGimpsey is engaged in rendering legal, accounting, or other professionally services. If such assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any federal, state, or municipal tax penalty. Moreover, a diversified portfolio does not assure a profit or assure protection against loss in a declining market. UNIFIED PLANNING GROUP is an independent firm with securities offered through Summit Brokerage Services Inc., Member FINRA, SIPC