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The Value of Fixed-Income, Part 1

Taken from

December 27, 2010

After the market turbulence of recent years, investors of all ages turned towards fixed-income investments. Here’s why.

In the wake of the 2008 stock market turmoil, many investors, unnerved by swings in the value of their stocks, searched for alternatives to buying equities. Over the past two years, there was a surge of interest in fixed-income investments, which return income to their owners but generally don’t appreciate in value substantially (as stocks can). Such fixed-income investments include interest-bearing bank accounts, Treasury bonds, annuities, certificates of deposit, and money-market funds. (Social Security is also essentially a fixed-income investment, if an involuntary one.) And many of these instruments can be bought within fixed-income exchange traded funds, which have seen major growth in the past two years; (see chart below), fixed-income ETF assets increased by 78% percent in 2009 and an additional 21 percent in the first six months of 2010.  

As those numbers suggest, the trend was at its most powerful in 2009 and ebbed in the first half of this year; in recent weeks, the extension of the Bush-era tax cuts has created renewed interest in domestic equities and investors have actually started pulling money out of bond funds and returning to equities.

To some readers, fixed-income investing might sound like something only relevant for retirees or people nearing retirement. After all, financial instruments such as money market funds and annuities are generally thought of as conservative, more predictable than equities but offering less potential upside. And it’s true that many investors who no longer receive a paycheck rebalance their portfolio, de-emphasizing more aggressive growth assets in favor of those that primarily generate income. They’ve been saving for retirement, and they need cash for living expenses.  It’s also true that we’re likely to see even more of this in the imminent future: Millions of Baby Boomers are now starting to retire, and they’ll be looking at fixed-income investments in the hope of providing themselves an income stream while diminishing the level of risk in their portfolio.

But retirement needs aren’t the only reason why an increasing number of investors, regardless of where they are in life, are devoting a portion of their portfolios to fixed-income investments. Fixed-income investments can add diversity to portfolios, always an important element of portfolio management.  And some fixed-income investments, such as municipal bonds, can have significant tax advantages over other investment vehicles. Finally, as I mentioned before, many investors moved away from equities toward more predictable investments after the stock market upheaval of 2008 and early 2009.

There’s just one problem: The yield on many fixed-income investments aren’t very high right now. That’s because they’re tied to the interest rate paid by the Federal Reserve, and given the economy’s almost non-existent inflation rate, the Fed’s interest rate is hovering just above zero, as of December 10, 2010. If rates rise, income returns on fixed-investment will also rise, but the value of instruments like bond funds could fall (bond prices move inversely to rates) and payouts on current fixed-income investments could be worth less due to the effects of inflation.  

At the moment, many traditional fixed-income investments are offering such low yields, they don’t seem very appealing. Back in the mid-1990s, Americans got used to banks advertising checking accounts paying interest rates of 5 percent or more. Now, major banks are offering checking account interest rates of well under 1 percent, and five-year certificates of deposit just above 1 percent, as of December 10, 2010. Yet there are still good reasons to consider fixed-income, especially when combined with the low fees and diversifying impact of exchange traded funds.

Not all parts of the bond market react the same to changes in rates or other macro-economic activity. With the wide range of ETFs now covering the Fixed Income markets, investors can fine-tune their fixed-income investments with the advantages of ETFs in most cases. I’ll address this growing market in my next post.

Diversification may not protect against market risk. Bonds and bond funds will decrease in value as interest rates rise. Federal or state changes in income or alternative minimum tax rates or in the tax treatment of municipal bonds may make them less attractive as investments and cause them to lose value.

Sources: Investment News, Index Universe, Citibank, Seeking Alpha, Federal Reserve, as of December 10, 2010


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