Fixed Y Securities

Fixed income refers to any type of investment that yields a regular (or fixed) return. For example, if you lend money to a borrower and the borrower has to pay interest once a month, you have been issued a fixed-income security. When a company does this, it is often called a bond or corporate bank debt (although "preferred stock" is also sometimes considered to be fixed income). Sometimes people misspeak when they talk about fixed income. Bonds actually have higher risk, while notes and bills have less risk because these are issued by government agencies. The term fixed income is also applied to a person's income that does not vary with each period. This can include income derived from fixed-income investments such as bonds and preferred stocks or pensions that guarantee a fixed income. When pensioners or retirees are dependent on their pension as their dominant source of income, the term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures. Fixed-income securities can be contrasted with variable return securities such as stocks. To understand the difference between stocks and bonds, you have to understand a company's motivation. A company wants to raise money, and it doesn't want to wait until it has earned enough through ongoing operations (selling products or providing services). In order for a company to grow as a business, it often must raise money; to finance an acquisition, buy equipment or land or invest in new product development. Investors will only give money to the company if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond or bank loan) or (preferred stock). While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed-income industry: •

The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest.

•

The principal (of a bond) is the amount that the issuer borrows.

•

The coupon (of a bond) is the interest that the issuer must pay.

•

The maturity is the end of the bond, the date that the issuer must return the principal.

•

The issue is another term for the bond itself.

•

The indenture is the contract that states all of the terms of the bond.

People who invest in fixed-income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on, but not consume principal. This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment. When the bond matures or is refinanced, the person will have their money returned to them. Interest rates change over time, based on a variety of factors, particularly rates set by the Federal Reserve. For example, if a company wants to raise $1 million and not a lot of people in the market have free cash to lend, the company will have to offer a high rate of interest (coupon) to get people to buy their bond. If there are a lot of people in the market trying to get a return on their money, the company can offer a lower coupon.

To complicate matters further, fixed income securities are actually traded on the open market, just like stocks. To understand this, first realize that bonds are usually created in round face values, for example $100,000. If the current yield (interest rate) of newly issued similar bonds is 6% per year, and you are buying a bond with a coupon rate below 6%, then you can get the bond at a discount (below face value of $100,000), which brings your rate of return on that bond to 6%. Similarly, if the coupon rate of the bond you are buying is greater than 6% you will have to pay a premium for the bond to bring the rate of return down to 6%. There are also index-linked, fixed-income securities. The most common and an example of the highest rated variety of this kind could include Treasury Inflation Protected Securities (TIPS). This type of fixed income is adjusted to the Consumer Price Index for all urban consumers (CPIU), and then a real yield is applied to the adjusted principal. This means that the US Treasury issues fixed income that is backed by the full faith and credit of the US government to outperform the CPI (e.g. to outperform the inflation rate). This allows investors of all sizes to not lose the purchasing power of their money due to inflation, which can be very uncertain at times. For example, assuming 3.88% inflation over the course of 1 year (just about the 56 year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US Treasury real yield on October 19, 2006, for a 5 yr TIPS), the adjusted principal of the fixed income would rise from 100 to 103.88 and then the real yield would be applied to the adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%. TIPS moderately outperform conventional US Treasuries, which yield just 5.05% for a 1 yr bill on October 19, 2006. By investing in such fixed income, index linked fixed income securities, consumers can exceed the pace of inflation, and gain value in real terms. All fixed income securities from any entity have risks including but not limited to: •

inflationary risk

•

interest rate risk

•

currency risk

•

default risk

•

repayment of principal risk

•

reinvestment risk

•

liquidity risk

•

maturity risk

•

streaming income payment risk

•

duration risk

•

convexity risk

•

credit quality risk

•

political risk

•

tax adjustment risk

•

market risk

•

climate risk

^^^^^

Why should one invest in fixed income securities Fixed income securities offer a predictable stream of payments by way of interest and repayment of principal at the maturity of the instrument. The debt securities are issued by the eligible entities against the moneys borrowed by them from the investors in these instruments. Therefore, most debt securities carry a fixed charge on the assets of the entity and generally enjoy a reasonable degree of safety by way of the security of the fixed and/or movable assets of the company. The investors benefit by investing in fixed income securities as they preserve and increase their invested capital and also ensure the receipt of regular interest income. The investors can even neutralise the default risk on their investments by investing in govt. securities, which are normally referred to as risk-free investments due to the sovereign guarantee on these instruments. The prices of debt securities display a lower average volatility as compared to the prices of other financial securities and ensure the greater safety of accompanying investments. Debt securities enable wide-based and efficient portfolio diversification and thus assist in portfolio risk-mitigation. ^^^^^^

Fixed income and your portfolio-I Mention your investment portfolio, and many people jump to the conclusion that you hold an array of stocks. But savvy investors know that equities aren't everything. The key to developing a sound portfolio is striking the right balance between potential reward, risk, and your future financial needs. Fixed-income securities can be an excellent way to diversify your portfolio. They are also crucial for your tax planning. Fixed-income securities represent the debt of domestic financial institutions, companies, banks, and government issues. In essence, when you buy a fixed-income security, you are lending money to the issuer for a specified period of time. In return, you expect the issuer to make regular interest payments (annually, semi-annually, quarterly, or monthly) and to pay back the face amount on the maturity date (the end of the specified period for the loan). Fixed-income instruments in India typically include company bonds, fixed deposits and government schemes. One of the key benefits of fixed-income instruments is low risk i.e. the relative safety of principal and a predictable rate of return (yield). If your risk tolerance level is low, fixed-income investments might suit your investment needs better. Most fixed-income securities offer a relatively stable and predictable income flow. The amount of interest the issuer has agreed to pay, the coupon rate, is set at issuance and remains the same until maturity: hence, the term "fixed income." The different fixed-income vehicles in the market allow you to choose from a range of credit ratings and maturities. Fixed-income securities provide the flexibility to structure a portfolio tailored to your specific investment objectives and tolerance for risk.

•

Most fixed-income securities offer a relatively safe and predictable income flow.

•

The coupon (the amount of interest the issuer has agreed to pay) is set at issuance and remains the same until maturity; thus, the term "fixed-income."

•

The different fixed-income vehicles in the market allow you to choose from a range of credit ratings and maturities (generally one day to 30 years, with some as long as 100 years). This diversity helps improve your management of risk.

•

Fixed-income securities provide the flexibility and liquidity needed to structure a portfolio tailored to your specific investment objective. As with stocks, there are essentially two ways to make money from bonds: (1) Capital gains, which are achieved by selling a bond for more than it cost to buy, and (2) The receipt of periodic interest payments. Corporate bonds historically have been viewed as safer than stocks. A portion of your investments should be in fixed-income securities based on your risk tolerance and risk capacity levels (Use our risk analyser to determine your profile). The money that you are likely to need in the short-term should be invested in fixed-income instruments. If you need a certain predictable stream of income, fixed-income instruments are recommended. ^^^^^^

Fixed Income Securities India Securities are financial instruments that represent some value. A Debt or Fixed Income Security represents a creditor relationship with a corporation, government, bank, etc. Generally debt instruments represent agreements to receive certain cash flows depending on the terms contained within the agreement. Fixed-income securities are investments where the cash flows are according to a predetermined amount of interest, paid on a fixed schedule. The different types of fixed income securities include government securities, corporate bonds, debentures, etc. A brief detail about some of these investment options are given below. Government Securities- G-Secs are issued by the Reserve Bank of India on behalf of the Government of India. Normally the dated Government Securities have a period of 1 year to 30 years. These are sovereign instruments generally bearing a fixed interest rate with interests payable semi-annually and principal as per schedule. G-Secs provide risk free return to investors. Corporate Bonds- Corporate Bonds are issued by public sector undertakings and private corporations for a wide range of tenors normally upto 15 years although some corporates have also issued perpetual bonds. Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends, of course, upon the particular corporation issuing the bond, the current market conditions, the industry in which it is operating and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds. Debentures – Debentures are instruments for raising loan by a Company. They evidence an

acknowledgement of debt with an obligation to repay the sum specified alongwith interest as specified. They are subject to provisions of the Companies Act, 1956 and sections 117 to 123 relating to issue, appointment of debenture trustees, creation of Debenture Redemption Reserve Account, etc., specifically apply to them. As per section 125(4) of the Companies Act, registration of charge for purpose of issue of debentures is mandatory. Debentures form a part of the Company’s capital structure but not a part of the share capital. ^^^^^^^

PART ONE: The Very Basics of Income Investing In the beginning, there was money! And the investment gods, in their infinite wisdom, created the corporation and it's two forms of capitalization: Equity and Debt. Corporations raise money by selling shares of ownership called Common Stock, and by borrowing money through a variety of instruments which range from all forms of Bonds, Notes, and Debentures, through a similarly confusing array of Preferred Stocks. Companies pay investors for the use of this borrowed capital with interest and dividends, respectively, and such payments are expressed as Fixed Amounts that are due on specific dates throughout the year... thus, Fixed Income Securities. Only the income is fixed, market values of all securities do fluctuate, for various reasons.. Although neither type of payment is guaranteed, the corporation generally promises to pay all of its Bond Interest and Preferred Stock Dividends before any payments can be made to Common Stockholders. Additionally, Corporate Bonds (and Preferred Stock) may sometimes be fully or partially insured, and/or convertible under certain circumstances into the common stock of the issuing company. Still, Income Investing is much safer and significantly more secure than Equity Investing and is, therefore, one of the tools used to keep the level of overall investment portfolio risk under control. Income securities may also be callable, at various times, fully or partially, and usually at face value... certainly something to be aware of when purchasing. Is a corporation more likely to call-in a bond or preferred stock when interest rates are rising or falling? Well thought out Asset Allocation Plans always allow for a portion of the Investment Portfolio to be invested in Income Securities, particularly once the six figure level has been achieved. New Article: Income Investments Save Asset Allocations The Federal Government and its Agencies are huge issuers of notes and bonds, and Government Fixed Income Securities are the safest and most secure of all Income Vehicles. Both Principal (the face amount of the security) and Interest are guaranteed by the "Full Faith and Credit of the United States of America". These are absolutely the safest of all securities issued by any entity, anywhere on the planet. The Income Investor must be aware that he is accepting the lowest possible interest rate available in the market place as part of the price of these guaranteed securities. And, they fluctuate in market value in the same manner as corporate and municipal securities, but are rarely called. When held to maturity, there is virtually no risk associated with them. But until maturity, Virginia, prices of Government Securities do fluctuate... over and over again! Yes, I wanted to repeat that!

States, Municipalities, and their Agencies are also significant issuers of Fixed Income Securities. The most important feature of these securities, called Municipal Bonds, is that the interest they pay to investors is totally exempt from Federal (and Home State) Income Taxes. There have been an insignificant number of defaults in United States Municipal Bond history, and those few have nearly always involved Revenue Bonds. Municipal General Obligation bonds are generally considered to be nearly as safe as Federally issued Fixed Income Securities. As with Corporate Bonds, investors must look to the Bond Rating and the current yield of the bond itself to determine the quality of the issue. A suspiciously high yield should be an indicator to the investor of increased risk. When held to maturity, there is virtually no risk associated with these securities. Still, many Municipal Bond issues are insured as to principal, interest, or both, thus assuring an even lower yield to the investor. Investors pay dearly for each level of protection they require, and experience will teach you that insurance and the accompanying AAA rating is overkill. Investors can also obtain shares of Investment Company Closed End Mutual Funds (CEFs) that invest in all of the securities mentioned above in many different ways, and Industry Specific Income Securities that specialize in various kinds of royalties, all kinds of commercial, residential, and industrial Real Estate, and Mortgage Income. There are right and wrong (high risk vs. lower risk) ways of investing in theses types of securities as well, and they have become the security of choice for Sanco Services because of their liquidity, ease of trading on the NYSE, monthly cash flow, etc. In higher interest rate environments, individual Preferred Stocks, and Bond Unit Trusts (Corporate and Government) become more attractive than they are at lower rates. All Income Securities are Interest Rate Expectation Sensitive securities, and as such, their market price will always vary inversely to the anticipated direction of interest rates. WHAT! In the simplest of terms, this means that all Bond, Preferred Stock, REIT (Real Estate Investment Trusts), etc. prices will rise in market value when lower interest rates are expected and fall if higher interest rates are anticipated. The amount of movement in the price of these Interest Rate Sensitive, Income Securities, will vary depending on: the Quality Rating of the Issuer of the Security, and the amount of time until the Maturity, or Call Date (if applicable) of the issue. Sector specific CEFs will also react to expectations other than those affecting interest rates... even more so. Income Security Prices themselves have no impact either on the actual Quality of the securities or the ability of issuers to pay interest. Therefore, it is critical to investors that they learn to take advantage of lower prices/higher yields rather than to lose sleep over them! This seems to be a whole lot more difficult than it sounds. In and of itself, in all the years that I have tended to people's investment portfolios, this is the area where the most investment errors are made, and simply out of ignorance. Income Securities are, by their very nature, Long Term Holdings, AND for a myriad of reasons, higher interest rates, in recent years, have generally been associated with longer maturity dates. The key issue in Income Investing is the amount of income being received. Guess work about the future direction of interest rates is something that

should be avoided. Similarly, the Income portion of a portfolio must be Performance Analyzed separate and apart from the Equity portion of the portfolio. Note: At the top of the Sidebar to your left are links to three recent articles on Income Investing: Expectations, Selection, and Management. PART TWO: Understanding Fixed Income Securities The purpose of owning Income Securities is quite simply the generation of a secure cash flow that can either be spent or reinvested at prevailing interest rates (i.e., compounded) until it is needed. The classical long term goal of an Investment Program is to live off the income produced by one's assets, without ever having to invade the principal. Therefore, it should be clear that it is never smart, or savvy either to defer the receipt of income for any reason, ever, or to put off the development of the income stream until the last minute. This is part of what Asset Allocation is all about! Done using the Working Capital Model, it assures the constant growth of the income contribution to the portfolio. Investing in Income Securities is never a hedge against something that may or may not happen in the future, nor is it a place to stash your stash until some other event takes place. Investment Income comes in just two varieties: interest on debt securities and dividends on stocks and other hybrid securities, such as Preferred Stocks and Closed End Mutual Funds/Investment Companies that are distributed to investors in the form of Equities. Capital Gains income is a real possibility as well, but it is not considered part of the Fixed, Base Income. Rents and royalties can be classified as fixed and/or variable income. Income Investing has always been the orphan of the Investment World because it just doesn't generate the hype and excitement that the "Shock" Market routinely provides. Still, it is important for investors to understand that there is as much of a need for income in the day to day or short run of running an investment portfolio as there is the obvious need for income in a person's retirement years. Income Securities generally trade in larger dollar quantities than stocks, particularly when initially sold to the public, and the mark up on them is both invisible and huge... upwards of 3% in most instances. Many Fixed Income Securities are placed directly with (sold to) mutual funds, insurance companies, investment companies, and other entities which will package (even restructure) them for sale to the Individual Investor in some form of Income Product. Government Agencies do the same, particularly with respect to mortgage investments. For the most part, individual investors have to rely upon their advisors to guide them in their selection of appropriate Income Investments where, believe it or not, there is more room for mistakes, ignorance, misinformed advice, inexperience, and general confusion than there is in the Equity Market. The reason for this is that mark-ups are not revealed in transactions, and both investors and their advisors have many misconceptions about these investment vehicles. Fixed Income Yields and security prices generally change much more slowly than Stock Market prices, and it can actually takes years for interest rates to move in either direction by a few points. At the same time, a trend in interest movements is likely to last longer than a trend in stock prices. There is abundantly more economics than there is

emotion involved with interest rates movements, creating a more stable playing field for the individual investor... theoretically. Income Investing should be much easier than it is, and should rarely produce an anxious moment. If you are thinking long term, as you should be in this area, the rules become simple and few: •

RULE ONE is to always seek out the longest duration, Investment Grade Only, securities with the highest (reasonable) yields.

•

So long as you follow RULE ONE, RULE TWO is to focus on the Cost Basis of your Fixed Income Securities and ignore their Market Value fluctuations.

•

RULE THREE is to stay focused on the income generated by these securities, and to make decisions that grow that income annually.

All Interest Rate Sensitive Securities are Created Equal... pretty much! This means that if your bonds are up or down in price, so are everyone else's. If your fund is down, Johnny's fund couldn't do better unless there are significant Quality or Duration differences involved. Therefore, don't ever switch from one Fixed Income Security to another for emotional (fear or greed) or other similarly superficial reasons. •

Investors should almost never switch from one fixed income fund to another, OR even worse, take losses on fixed income to move into something else entirely, typically a peaking Equity Market.

•

Another basic rule is to avoid yields that are a great deal higher than normal. Caveat Emptor! In one sense, Fixed Income Investing and Equity Investing are identical...Junk is Junk.

To be a successful Fixed Income Investor you must get to the point where you understand that: •

Higher Interest Rates are a Good Thing, and

•

So, too, are Lower Interest Rates.

^^^^^^^