The Security of Rates Is A Big Feature of Fixed Income Investments
This aspect of bonds offers security to both bond issuers and investors though. There are two different types of risk here, one involving absolute fluctuations in interest payments and the other dealing with opportunity costs.
The absolute cost side would be risking situations during the life of the debt instrument where it would cost you more to borrow. With a variable rate instrument, this is the case, in other words if interest rates rise during the term of the debt, it will cost you more out of pocket for the interest.
If you lock in a certain rate and it turns out that you could have borrowed the money more cheaply at a future point in time, or would pay less if you had borrowed it with a variable rate based upon the interest rate market, this is an opportunity cost risk.
Both of these represents real risks, but the risk that costs you money out of your pocket, the absolute risk, is the one that may be seen to hurt more.
If you are looking to buy something and can either buy it now at a known price, or enter an arrangement where the price will be fixed later by the market, if you choose the latter, the price may rise to where you can no longer afford it.
The same thing can happen essentially with interest, and bond issuers very often will prefer the certainty of a known interest rate over a certain period to add more stability to their operations.
Bondholders often will also prefer the higher stability of fixed interest, especially if they are using these fixed income investments as personal income. If the payments go down too much, they may no longer be able to live comfortably on their investments, therefore the stability of a known return is seen as a plus generally.
Therefore, for income purposes, fixed rate bonds are seen as preferable, and since they are also generally seen as preferable by the bond issuers, we have a market and a pretty big market indeed with this type of investment.
So when we look at fixed income investments, while the most defining feature of them is that they produce fixed levels of income, it is usually equally important that this income be as stable as possible, because income stability is the primary goal here, not just any income.
Preferred Stock as Fixed Income
Another example of a fixed income investment is owning preferred shares in a company. While bonds are by far the most popular form of fixed income investments, some investors also choose to own preferred stock.
Preferred stock is more like a bond than a common stock, as common stock gets most of its appreciation from price fluctuations, where people mostly look to sell the stock at a higher price than they paid for it, and this is where most of the profit derives.
While common stock does often pay dividends, these dividends are not guaranteed and a company may or may not even pay a dividend over a certain period of time, at their discretion.
Preferred shares, like bonds, do pay out an agreed upon interest payment, called the coupon rate with bonds and the dividend rate with preferred shares, and this amount is the level of fixed income of the investment.
Although preferred shares do represent ownership in a company, it functions more like a loan to the shareholder, in the way that bonds do. It isn’t a loan per se, like a bond is, it instead represents a preferred claim on the income of the business, where the dividend rate will be paid out as long as the company makes a profit.
Given this, the valuation of preferred shares operates similar to bonds, based upon the opportunity cost of interest, what it would cost to get access to the funds today versus the actual interest or dividend that is paid.
Where preferred shares differ is that the likelihood that a company may be able to maintain its dividends can also factor into the price. If a company is doing poorly and does not have the means to pay out dividends to its preferred shareholders, the dividends are still owed, and will be put on the books as payments in arrears.
If a company is in this situation though, this may not bode that well for its preferred shareholders, as it indicates a higher risk that the dividend payments may not continue as planned. Conversely, a company doing extremely well can be seen as less risky to not be able to maintain their preferred share dividends.
This is somewhat similar to the rating system in bonds, where a bond’s value may fluctuate depending on changing credit ratings. However, with preferred stock, the rating is more tangible, you don’t get paid and are owed money. While bond ratings only really affect those who are buying or selling, in other words people just holding the bonds may not become that concerned, with preferred stock, the implications of poor business conditions causing preferred dividends to be suspended will be a significant event.
In the cases where the preferred shares are cumulative, the company will need to catch up with the payments to preferred shareholders before they can resume dividends to common shareholders, but only if they are cumulative. If not, the preferred shareholder may lose their dividend.
Ultimately, if the company goes under, the company’s creditors, including their bondholders, will need to be paid out fully before preferred shareholders are paid out. While preferred shareholders get preference over common shareholders, by the time it’s their turn to claim their assets, they may be nothing left to put a claim on.
Bonds Are Generally Better Suited to Fixed Income Investing
Since the intention with fixed income investments is to seek a stable return, investors who seek this will generally prefer bonds over preferred stock. While there are other considerations when considering choosing between the two, the fact that you own a piece of the company for instance, for the purposes of fixed income, it is better to be a creditor than an owner, since creditors are given preferential treatment.
This isn’t just the case if the company needs to be liquidated, this also happens on an ongoing basis. Dividends must be paid out of profits, meaning that after a company’s debts have been paid, if there is anything left that is. Bondholders are creditors, who are paid first, regardless of whether a company profits or not.
When interest payments to creditors, including bondholders, cannot be made as agreed, this is where the company becomes insolvent. A company may still be solvent and fail to meet its obligations to preferred shareholders though, meaning that interest payments to bondholders will always be paid unless the company goes under, while preferred shareholders may or may not be.
While the better companies will generate at least enough profit to make their dividends to preferred shareholders, some companies may not, those newer or those who are struggling more. The risk here therefore depends on the quality of the company, and with those who are very stable and reliable, there may not be that much of a difference in risk between these preferred shares and bonds.
The biggest difference between bonds and preferred stock as far as fixed income investments go is that you can buy bonds issued by governments, where with preferred stock you can only buy these with companies.
Since government bonds tend to be more stable and reliable, as governments aren’t bothered by operating losses unless they are very extreme, these types of bonds tend to be very stable and reliable.
There’s more to putting together a fixed income portfolio than just looking for stability though, as more stable investments pay less interest, because they don’t have to. Many investors look for a mix between more and a little less stable investments, and while they do look to keep risks low, they also may not require them to be extremely low, as they would be with U.S. treasuries for instance, and may want to benefit from the better returns that less reliable but acceptably reliable investments may provide.
Looking to balance these risks with returns is a big component of putting together a fixed income portfolio, and a lot of this has to do with what sort of returns a particular investor requires to meet their income objectives.