Goals of Fixed Income Investments

The biggest and most obvious goal with fixed income investments is to generate income from them. Income in this sense means interest income, money that is made apart from any change in price of the instrument.

Capital gains and losses only really occur when a position with an investment is closed out, meaning either selling it if it was a long position or covering it if it was a short sale. While fixed income investments are often traded with a view to capitalize on price changes, how fixed income investments differ from other investments is that a lot of what goes on with them on the profit side does not require exiting your position with them.

Goals of Fixed Income InvestmentsIf an investor buys a stock, for instance, to seek long term capital appreciation, the hope is that when the time does come to sell it, it will have appreciated to the extent that a good return will be made on it, and a better one than would have been gained through more conservative investments.

If a loss occurs, which is well within the realm of possibility, then the investment has failed of course. If one’s strategy is to hold the stock until some future point in time, perhaps to a certain age, or other non-market criterion, then this actually exposes the investment to the maximum amount of risk.

Many traders will generally have a stop loss with their trades, a price point where the trade will be exited due to conditions of the trade deteriorating to the point that the trade becomes deemed failed.

If you are looking for an instrument to break out from a trading range for instance, and it fails to do so and instead moves too much in the other direction, the idea behind the trade has been violated, so one would put a stop here. This stop would limit one’s risk to that price plus perhaps a little market slippage, the risk that the order may end up being filled a little beyond the stop due to market conditions.

How Long Term Goals with Stocks and Fixed Income Investments Differ

With buy and hold strategies, there are no stops at all that are used, and if the investor stays the course, they will continue to hold it in all conditions save for the non-market-based criterion, when one retires for example. Our retiring has nothing to do with the market for the stock though, it doesn’t care, and therefore the condition is functionally immaterial.

We are told that this is the correct way to invest, as stocks will eventually move up over time, and when we give them enough time, we may expect that. This is not an entirely unreasonable approach, but what we tend to miss with this is that all investments must be judged according to their opportunity cost, not that they regained their value over a certain time period, but how other investments may have fared over this particular time.

Should we choose to take this approach, to not set any market based conditions on the holding of our investments, fixed income investments offer us the opportunity to take the market risk that has so many stock investors worried all the time right out of the picture.

There need not be a stop loss of any sort with fixed income investments, as we can simply choose to never sell them. With bonds for instance, we can just hold the bonds until maturity, earn a guaranteed rate of interest during the life of the bond and get our principal back.

While we may still be up or down on the capital side of things, given that we will be purchasing the bond above or below its value at maturity, its par value, depending on the market conditions at the time of purchase, this will be a known amount which we will be fully aware of at the time of purchase.

If, for instance, a bond is trading at 5% over its par value, we know that this will result in a capital loss of that 5% at maturity, and we will then calculate whether the return over the life of the bond will be sufficient to compensate for this.

Therefore, the entire picture can be available to us right from the start with a bond, and aside from the risk of default, there are no other uncertainties present in the investment, if we do indeed hold it to maturity.

When we look to the goals of fixed income investing, the ability to eliminate market risk by simply holding the investments can figure in very prominently indeed as far as the reasons to hold fixed investments go.

While the upside here is limited to the yield of the instrument, the interest rate plus the price adjustment based upon what will be ultimately received, it is an upside that not only is less risky than similar buy and hold strategies with stocks, the overall risk can be brought down to virtually zero if this is done with the most solid of fixed income investments, like treasuries.

One may look to manage this and also seek capital appreciation by looking to time fixed income positions, and even take short positions in bonds in the futures market or with contracts for difference should one desire, but all of this is optional as one need never sell these instruments based upon the market.

So, when we compare stocks and fixed income investments here, the more disposed we are to invest for the long term, the more we should be willing to look at bonds in particular to comprise a significant component of our portfolios, in an effort to manage risk.

Fixed Income To Balance Portfolios

The concept of seeking to reduce or eliminate market risk is related to the goal of looking to diversify one’s portfolio by seeking to balance the growth component, stocks, with the income component, mostly consisting of bonds but also including preferred stock.

The idea here with diversification is to look at the value of one’s positions and look to reduce drawdowns. For instance, if you had all of your money in the stock market and the value of your shares declined by 50%, the value of your portfolio would decline by the same amount.

This might not matter so much if you were planning on holding the stock for a lot longer, for instance for 10 or 20 more years, and still expect the stock holdings to deliver an acceptable rate of return over the life of the investments.

In some cases, it might still be preferable to be fully invested in the stock market, if those expected returns were great enough that we may expect a better rate of return regardless. This has been the case at certain times, during long bull markets, although at the time of making the investment it is near impossible to predict the future of the stock market long term.

In any case, stock plays do come with some real risks, and these risks express themselves not by drawdowns with long term investing, but by way of what we may end up as far as returns go when we sell the stocks.

In leveraged positions, drawdown risk can be very real, and a certain decline can cause your entire position to be lost. If you are leveraged 2:1 in the situation where your stocks go down 50%, you can go broke.

Just buying the stock outright without margin takes most of this risk out of the picture, and the only thing you have to worry about is the company going out of business. Otherwise, the risk isn’t with how low it may go, it is what price may you get later on when you sell, if you do stick to your guns and ride it out. If the value of your portfolio declines along the way, the only thing we need to worry about is how this may affect our overall outlook as far as where it may be when we need to sell it.

If we instead put a certain percentage of our investment funds in fixed income securities, we can look to mute these movements against us in the stock market, to a level that we prefer.

In our example, if we invest 50% in stocks and allocate 50% to bonds, assuming that bonds don’t change in price, a 50% loss in the value of our stocks only produces a 25% loss of value in our portfolio overall.

Depending on the situation, bonds may go down in value as well, but they tend to decline to a lesser degree than stocks do during bear markets, and this is because of the greater stability of bonds due to the intrinsic value of their interest payments.

The Goal of Reducing or Eliminating Market Risk

We could say that the supply and demand of the market is the biggest driver of stock prices, almost fully driving it, while with bonds, given that they are worth a certain amount of interest each year, interest rates will be the driving force more than anything. If too many people sell and exit the bond market, at some point others will step in to capture the additional value this creates, as it will increase the yield on the bonds when they can be bought at a lower price.

Stocks being a bargain when their price goes down is more a matter of perception, as ultimately the market must perceive this additional value and act upon it by increasing demand. With bonds, the creation of this additional value is not really dependent upon the market, as this value can be expressed mathematically.

Historically, the more you focus your portfolio on the income side, the more you control risk, but this has come at a price. Stocks do outperform bonds in the long run, averaging about 10% long term versus fixed income investments, which only average half as much in return.

Managing risk is at least as important as managing returns, and perhaps even more so. Asset allocation allows us to choose the level of risk we wish, anywhere from going all in with particularly volatile stocks and holding regardless of market conditions, to putting all of our money in U.S. treasuries and holding them until maturity.

There’s also the goal of generating income from income investments, in a way that stocks don’t provide anywhere near as reliably. Income generation isn’t limited to fixed income investments, it’s just that they allow us to achieve these goals more reliably.

There are many who buy and hold certain types of stocks and look to use dividends as income, but these dividends are less reliable than interest payments from bonds or even from preferred stock, and holding common stock long term exposes us to the full brunt of market risk.

Fixed income investments are well suited to the goal of reducing risk and increasing the stability of income from the investments, goals that many older investors seek. Fixed income investments are not just for those in their later years though, as a certain allocation to this class of investment can be wise at any age.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.