“Understanding” boils down to the development of reasonable expectations: just how do you expect the market value of your income purpose securities to react to varying market, interest rate, economic, political, atmospheric, and “other” conditions”… and, does it really matter?
Few investors grow to love volatility as I do, but most expect it in the market value of their equity positions. When dealing with “income purpose” securities, however, neither they, their guru/advisors, nor market commentators are comfortable with any downward movement whatsoever.
- Not to make excuses for them, but most professional and media folk think in terms of the individual bonds and other debt securities that Wall Street markets to brokerage firms and other large investment entities. Bond traders hate to discount their inventory due to higher interest rates… it’s bad for year end bonuses. But their bond market disaster is the individual investor’s opportunity to buy the same amount of income at a lower price.
Most investors are also more receptive to loss taking advice on income securities than they are with respect to equities… always the effect of a “market value” rather than an “income production” focus… and a well kept Wall Street secret.
The list below describes some important characteristics and concepts involved with investing in income purpose securities. Familiarization with these will aid in the development of valid “performance” expectations. Doing so will also help develop an appreciation of this important (and somehow not too often mentioned) relationship: changing market values (in either direction) rarely have any impact on the income being generated by the security.
- Confucius say: keep your eye on the ball, you can’t buy groceries with market value or total return, only income pays the bills… without depleting sacred capital
General attributes of income purpose securities:
- They generate a predictable stream of interest, dividend, rent, royalty or other income.
- They pay income in specific amounts on specified dates.
- Their risk of financial loss varies dependent upon security type, issuer quality, and maturity, BUT, all normal income securities are considered far less risky (financially) than the common stock of their respective issuing entities. State government paper is less risky; federal government issues carry no financial risk at all.
- The purpose of the income asset allocation of an investment portfolio is the production of income in an amount large enough to assure: annual growth of income producing capital and annual growth of income production.
- High dividend common stocks (utilities, etc.) are not included within the income purpose security definition, although they may be less risky than other equities.
- Bonds, loans, and other interest bearing securities are issued by both corporations and government entities and have maturity dates upon which the principal is returned to investors.
- Income securities that are guaranteed as to principal and interest, or protected by “safety mechanisms” of any kind always bear a lower yield than otherwise similar securities.
- Generally, fluctuations in market value have nothing to do with the financial viability of the security issuer. Most often, they are the result of anticipated changes in the direction of interest rates, or the tax code.