Scratchpad

If you want to invest in stocks on the long side yet you fear a bear market, then you don’t have many options. But they are out there, including Consumer Staples Select Sector SPDR ETF (XLP) and Vanguard Dividend Appreciation ETF (VIG). XLP will not appreciate in a bear market, but it will hold its own better than an ETF like SPDR S&P 500 ETF (SPY). By investing in what consumers need opposed to what they want, you will be limiting downside risk while also collecting a 2.66% dividend yield. XLP also has a low 0.15% expense ratio. If you want to maximize your potential, strongly consider implementing a dollar-cost-averaging strategy, knowing that it will only be a matter of time before XLP begins to head north again. Just use caution and take it slow, because deflationary environments can be damaging to any ETF with long exposure.

VIG won’t hold up quite as well, but you will be investing in companies that hike their dividends, which indicates they’re fiscally-sound companies that should be capable of weathering the storm. VIG should weather the storm as well. Currently, VIG comes with a 2.44% yield and a low 0.10% expense ratio. (For more, see: Traders Look to Dividend Funds.)

The Bottom Line

Many investors seeking resiliency through diversification will opt for SPY, but that doesn’t make sense because it means you will be exposed to all large-cap companies across all industries. Instead, if you want to stay on the long side and seek diversification and yield, then stick with the areas of the market that will offer the most resiliency. And if you seek resiliency with the potential for appreciation and yield, then consider ETFs that track Treasuries. (For more, see: The Importance of Diversification.)

Taxes
Taxes are an important consideration for most investors. However, tax considerations become even more important when an investor focuses upon generating income. That is because many individuals will find that income is taxed at a higher rate than capital gains.

Tax avoidance strategies are heavily dependent on an individual’s unique circumstances, and should be devised in consultation with an accountant or financial advisor. However, one simple step that some investors can take is to hold income-generating assets in tax-sheltered accounts (such as retirement accounts) while holding non-income-generating assets in fully taxable accounts. Such an approach would help to minimize current taxes on income generated from the overall investment portfolio. However, this approach would not work if the investor needs portfolio income to meet current cash flow needs. In these circumstances, an investor will have no choice but to receive the income and pay taxes on it. (For more, be sure to read A Long-Term Mindset Meets Dreaded Capital-Gains Tax.)

High Dividend-Paying Stocks
Dividends change over time as companies become more or less profitable and as investors shift their emphasis from capital appreciation to current income. However, there are certain types of stocks that have traditionally paid large dividends. Historically, companies that are large and well-established pay higher dividends than those that are small or new. Therefore, investors are probably better off focusing on an index such as the S&P 500 for dividends as opposed to an index such as the Russell 2000.

Additionally, rapidly growing industries and companies often pay low (or no) dividends because they prefer to reinvest their profits into the business. On the other hand, slower growing industries and companies have a tendency to offer higher dividend payouts. For instance, technology and biotech companies often pay little or no dividends while utility and drug companies are well known for offering high dividend yields. (For more, check out Dividend Facts You May Not Know.)

Safe Stocks
In many instances, it may be appropriate for an investor whose primary portfolio aim is safety and income to own some stocks. In these instances though, the investor will likely wish to minimize the risk of their stock portfolio to the extent possible. One way to do this is to invest in broad-based indexes of stocks as opposed to individual stocks. Investing in this manner produces greater diversification and reduces the risk that a large holding of a single stock will perform poorly. Generally speaking, high dividends come from mature, stable companies with consistent earnings streams. These are often the same companies whose stock prices are unlikely to display exceptional volatility. Therefore, a focus upon income generating stocks can often also result in a portfolio of relatively low volatility stocks.

Investors should be aware of the relative stability of the dividends they are receiving from their stocks. While coupon payments from bonds or certificates of deposit are contractually guaranteed, dividends are paid at the discretion of the company. While many companies are committed to paying dividends at a consistent level, this can and does sometimes change. For instance, when a company experiences financial difficulty or the overall economy enters a downturn many companies choose to conserve cash in order to fortify their balance sheets. A common way in which they do this is to reduce or eliminate the dividend payout to common shareholders. Investors who depend on stock dividends to meet a portion of their living expenses should carefully calculate the impact that this could have on their finances.

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Bonds provide consistent income due to their periodic coupon payments. Furthermore, bond issuers are contractually obligated to make these coupon payments; in most instances failure to do so allows bondholders to force the issuer into bankruptcy. Therefore, bond issuers view timely payment of all interest and principal as an extremely high priority. This enhances the likelihood that bondholders will receive their payments as scheduled.

Corporate bond coupon payments are considered more stable than company dividend payments. That is because companies are legally bound to pay interest on their bonds before considering payment of any preferred or common stock dividends. Finally, many other investment options have infinite life spans, but bonds have stated final maturities. This means that, in the absence of a default, an investor knows exactly when they will receive their principal back as well as the exact dates on which they will receive income distributions in the interim. This cash flow certainty is an invaluable benefit to investors dependent upon portfolio income to meet their ongoing expenses.

Types of Bonds to Avoid
While most bonds make attractive additions to a portfolio designed for safety and income, there are some bonds that might not be appropriate. In constructing a safe portfolio, an investor should focus on investment-grade rated bonds. These are bonds that carry a minimum credit rating of ‘BBB’ or higher. Bonds that would fall into this category include US Treasury securities, U.S. government agency securities, most mortgage-backed securities (MBSs), investment grade rated municipal securities, and investment grade rated corporate bonds. Bonds that are considered less safe include high yield junk bonds (rated below BBB), emerging market bonds and some securitized products. (To learn more, see Junk Bonds: Everything You Need To Know.)

Although bonds carry a promise that the principal will be repaid at a stated maturity date, circumstances do arise in which an investor might want (or need) to sell their bond prior to maturity. In anticipation of this possibility, it is important to realize that the longer the maturity of a bond the greater an investor’s exposure to possible capital loss if he or she wishes to sell prior to maturity because long-term bonds are more sensitive to changes in interest rates. Therefore, investors interested in safety should concentrate on bonds with maturities of 10 years or less. Generally speaking, bonds with maturities beyond 10 years do not offer substantially higher income, but they do carry a greater possibility of capital loss if an investor wishes to sell prior to maturity.

Investors interested in cash flow should also be aware that some types of bonds do not offer reliable income payments. For instance, zero coupon bonds do not offer current income but instead sell at a discount to their face values. With these bonds, investors profit from the difference between their purchase price and the final maturity value. In the interim though, investors do not receive any income, making them inappropriate for investors who depend on current cash flow.

Mortgage-backed securities and asset-backed securities also may not be appropriate for investors seeking consistent income. That is because instead of paying principal upon final maturity, these types of securitized products usually pay both principal and interest on a monthly basis, meaning that their cash flow pattern is more irregular than that from most other types of bonds. Because of these irregular cash flows, securitized products offer additional compensation, making them an attractive option for some investors. However, if stable income is a priority, an investor should consider other types of bonds.

Building a Safe Bond Portfolio
What is considered an “optimal” bond portfolio will differ depending on an investor’s circumstances and objectives, but some general advice can be given. A bond portfolio should be concentrated in highly rated, investment grade securities and should be invested in a wide range of maturities. When investing in bonds it is also important to realize that their long-term returns are lower than those of stocks. Therefore, fees have a greater impact on an investor’s total return in the bond market than in the stock market. This means that while focusing on fees it is always prudent when investing, it becomes even more important when constructing a bond portfolio.

Conclusion
This chapter has discussed how in many ways bonds are the ideal asset class for investors interested in safety and income. Investors should still tread carefully though, by minimizing their use of risky bond types such as emerging market bonds and high-yield bonds and concentrating their holdings in those bonds with maturities of 10 years or less. Investors interested in income should also focus on bonds that provide a steady stream of cash flows. An ideal fixed-income portfolio for many individuals will be comprised of government securities, government agency securities, high-grade corporate securities and high-grade municipal securities (in taxable accounts.) Such a portfolio will provide a steady stream of income with minimal risk of principal loss. (For more, check out Top 4 Strategies For Managing A Bond Portfolio.)

There are many investment options available at the local bank. Because they specialize in savings and investment alternatives that are designed to provide safety and income, banks can be a great place to store rainy day funds or cash that might be needed in the not-too-distant future. Although many banks also offer brokerage services, these services function similarly to those found at standalone brokerage firms, so in this chapter of the tutorial we will focus on traditional “bank products” as opposed to stocks, bonds or other products that might be sold through the bank’s brokerage unit. This chapter will also examine the benefits and drawbacks of traditional bank products when compared to brokered products.

Savings and Money Market Accounts
The most common investment alternative available at the bank is the savings or money market account. These accounts are often linked to a checking account. However, while checking accounts are designed to fund ongoing expenses, the savings or money market account is designed as an investment tool to collect excess funds. Benefits of a savings or money market account include easy access to funds, safety and familiarity. However, they generally provide very low returns and over time may not even keep pace with the rate of inflation. (See our Money Market Tutorial for more on the topic.)

Certificates of Deposit (CDs)
Certificates of deposit (CDs) are alternatives to savings and money market funds. With a CD, an individual deposits money in the bank and agrees to keep it on deposit for a stated period of time. The maturity of CDs can range from very short (one month) to fairly long (five years or more.) Regardless of the maturity, the two defining characteristics of the CD are that the money cannot be accessed prior to maturity (without penalty) and the rate of interest is usually higher than on a money market account.

CDs provide an attractive alternative for individuals saving for a rainy day or an anticipated future cash flow. Using CDs allows an individual to earn a slightly higher rate of interest than if the money had been left in a savings account and also helps remove the temptation to spend the money before it is truly needed. CD rates vary widely from bank to bank so it often pays to comparison shop before depositing money into a CD. (If you’re looking for bigger yields with limited risk, callable certificates of deposit (CD) might be right for you. (Learn more in our article Callable CDs: Check The Fine Print.)

Benefits of Bank Products
For investors concerned with safety, the most important benefit of investing at the bank is the principal protection that many of these alternatives provide. Many countries protect bank depositors against losses in order to guard against the possibility of a run on the bank and accompanying financial crisis. In the U.S., this protection comes in the form of FDIC insurance. FDIC stands for Federal Deposit Insurance Corporation, and the FDIC guarantees all deposits up to a certain level. Historically, the insurance amount has been $100,000, but in 2009 the insurance amount was temporarily increased to $250,000, and is scheduled to go back to $100,000 in 2014. This means that bank deposits, money market accounts and certificates of deposit are guaranteed by the U.S. government, making them among the safest investment alternatives an individual might consider. (Learn if your assets will be protected if your bank goes belly up, in Bank Failure: Will Your Assets Be Protected?)

Another advantage is that an individual often already has a relationship at the bank through a checking account, mortgage, or credit card. Therefore, using bank investment options does not require finding another firm with which an individual is comfortable doing business. Furthermore, consolidating one’s finances in a single location reduces the number of monthly statements and makes it easier to view an entire portfolio in a holistic manner. Finally, banks are often very well known in the community and a sense of familiarity can provide comfort to individuals unfamiliar with some other investment options.

Drawbacks
While investing at the bank provides many benefits, there are also some drawbacks to consider. Because banks primarily focus on very safe, short-term investment alternatives, the returns that they offer are generally low. Therefore, while some of the options available may be appropriate for investors primarily concerned with safety, investors interested in portfolio growth may need to look beyond the bank. Investors interested in income may also find that although there are attractive alternatives at the bank, better possibilities may exist for those investors willing to consider brokerage products.

A second drawback of investing in a bank is that many of their offerings suffer from a lack of liquidity. While brokered products (stocks, bonds, mutual funds) can generally be sold if an investor decides to reallocate their portfolio or needs the cash, many bank products do not have a secondary market available. This is less of an issue with money market accounts as an investor can simply request a disbursement from their account. However, in the case of CDs, investors who want their money prior to maturity often must pay a penalty for doing so. Penalties vary, but they can include the loss of interest earned on the investment, thereby negating the benefit of purchasing the CD in the first place.

Conclusion
This chapter has examined the role of bank products in an investor’s growth and income portfolio. Investors with small portfolios may find that the bank is an attractive starting point for an investment program. These investors can use money market funds or certificates of deposit as they begin to build their savings, later on expanding into other investment alternatives. Investors with larger portfolios should probably only consider bank products for a portion of their investment portfolio. In addition to bank products, these investors will want to purchase stocks, bonds, mutual funds and other investment products through a brokerage firm. These brokered products often offer greater return potential and may have comparable principal protection. Therefore, brokered products should make up the bulk of most portfolios. Investors can then use the bank for money market funds, certificates of deposit, and other short-term cash investments.

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Some individuals who are interested in safety and income may find that guaranteed income products are appropriate for their needs. While these products have their benefits, they also come with some drawbacks. Therefore, very careful consideration must be given prior to deciding whether these are appropriate. In this section, we will examine some of the characteristics of guaranteed income products as well as some of their benefits and drawbacks.

What is a guaranteed-income product?
There are two main types of guaranteed income products. The first of these, often referred to as an annuity, is essentially a product where, for an initial investment, an individual receives a guaranteed income stream for the remainder of his or her life. Annuities can be further broken down into fixed-rate and variable-rate products. A fixed-rate annuity guarantees a certain level of income for the term of the annuity; there is no risk that the cash flow from the product will decrease, but it is possible that inflation will gradually eat away at the value of the income stream. A variable-rate annuity is linked to the performance of an investment portfolio; income levels can fluctuate and even decline, but also have a better chance of keeping pace with inflation.

The second main type of guaranteed income product is the reverse mortgage. In a reverse mortgage, homeowners receive monthly payments from the reverse mortgage lender for the remainder of their lives. At the time of their death, the money they have received must be repaid to the lender by the estate, or possession of the house is granted to the lender. The decision to take out a reverse mortgage can be a difficult one to make, and cases of predatory lending have been reported. The AARP, an American organization dedicated to protecting the elderly and retired, has extensive free resources designed to protect senior citizens from potentially unjust lending practices. Anyone considering a reverse mortgage should gather as much information as possible before carefully considering whether a reverse mortgage is appropriate. (See Is a Reverse Mortgage Right For You? to learn more.)

Benefits of Guaranteed-Income Products
Guaranteed-income products essentially function like a pension plan by providing consistent monthly income payments to retirees. The main benefit of these products is that they remove the possibility that individuals will outlive their assets. Guaranteed-income products also make budgeting simpler because monthly cash flow is known in advance and is not dependent on financial market conditions. Finally, these products protect retirees from a sharp market decline that could harm their portfolio and force them to reduce their standard of living.

Drawbacks of Guaranteed-Income Products
While stable income for life is an enticing proposition, guaranteed-income products do have several disadvantages. One of these disadvantages is that individuals are generally locked into a relatively low rate of return. In other words, if an investor buys a diversified stock and bond portfolio instead of purchasing an annuity, portfolio growth over time may ultimately provide a higher level of income than the annuity offers. This means that in exchange for the peace of mind that comes with guaranteed income an individual sacrifices the possibility of higher returns. Costs can also be high with guaranteed income products and are not always readily apparent. This makes comparison shopping absolutely vital when considering these products.

A second drawback of guaranteed-income products is that they often suffer from a lack of liquidity. In other words, once an individual has committed to an investment in a guaranteed-income product they may not be able to reverse their decision. As well, these products may not keep pace with the rate of inflation. In other words, the income the individual receives will gradually be worth less in real dollar terms as time goes by. Some newer guaranteed-income products offer protection against this in the form of cost-of-living adjustments; however, it is important to remember that the investor does not get something for nothing. Future cost-of-living adjustments are priced into the cost of the product.

Guaranteed-income products are also unattractive options if an individual dies at an early age. The longer the individual lives, the more annual income payments they receive, and the higher the “return” on their initial investment. An early death results in fewer income payments, and therefore a less attractive investment return. Therefore, general health and life expectancy are important considerations prior to purchasing a guaranteed income product. It is also important to determine whether a spouse is going to be included in the guaranteed income contract; if so, plans should be made for the annual income payments to continue as long as either spouse is alive.

Finally, guaranteed-income products may not be appropriate options for individuals interested in leaving a bequest to their heirs. Individuals interested in providing for future generations might be better off building a traditional investment portfolio, spending what is necessary during their lives, and then leaving the remainder to their heirs.

Conclusion
Guaranteed-income products are perhaps the most controversial of the asset classes discussed in this tutorial. The benefit of these products is quite clear – the individual no longer needs to fear outliving their assets, and receives a consistent income for the remainder of their lives. However, there are significant costs to these products, including: potentially below-market returns, potentially declining real income, the risk of an early death, a lack of liquidity and reduced options for estate planning. Furthermore, high price structures are sometimes built into these products, and stories of predatory lending practices are common.

As the investment community begins to focus more closely on the needs of the retiring and the elderly, guaranteed-income products will likely become more standardized and more transparent. In fact, this process is already occurring. Still, individuals interested in guaranteed-income products are strongly advised to thoroughly investigate their characteristics, consult the free resources that are available, and do business only with the most reputable of providers. If individuals take these precautions, they may find that guaranteed-income products provide them with consistent income and peace of mind. (More on annuities can be found in our article Annuities: How To Find The Right One For You.)

The term “real assets” refers to a broad category of investment options that are characterized by the fact that they are tangible (as opposed to stocks, bonds, and CDs which are “paper” assets.) Real assets, also sometimes called hard assets, can play an important part in any investment portfolio – including those focused on safety and income. However, there are some important caveats and additional considerations that come with investing in real assets. This chapter will discuss several different categories of real assets and analyze their benefits and drawbacks when it comes to investing for safety and income.

Real Estate
Due to the sharp real estate correction that occurred between 2006 and 2009, many individuals are hesitant to invest in real estate. However, real estate has provided an attractive investment alternative for many years and will likely continue to do so in the future. When talking about real estate, we must differentiate between actually owning physical real estate and owning securities that represent an interest in real estate assets.

Physically owning real estate can provide an excellent store of value and a hedge against inflation. Rental properties (whether residential or commercial) can also provide relatively consistent cash flow for investors seeking income. However, there are several factors investors must consider when purchasing physical real estate. Physical real estate investment can be time-consuming and can be prone to difficulties that are not present in other types of investing (i.e. fixing a broken water heater or dealing with difficult tenants.) Furthermore, real estate often requires a substantial initial investment, which can make it difficult for smaller investors to build a diversified portfolio. Finally, real estate is less liquid than most other asset classes making it difficult for investors to raise cash if necessary.

An easier way of owning real estate is to purchase securities backed by real estate properties. These securities can be stocks (real estate investment trusts, or REITs) or bonds (mortgage-backed securities or commercial mortgage-backed securities.) When purchasing these securities, it is important to analyze the underlying real estate that backs them in order to determine how stable the cash flows are likely to be. Although owning real estate securities is easier in many ways than owning physical real estate, an investor does lose the benefit of owning a real asset. All told, investors with the willingness and ability to invest directly in real estate should probably do so; investors with smaller portfolios or those who are uninterested in the effort required for direct real estate purchases should consider securities backed by real estate. (For more on real estate investments, take a look at Investing in Real Estate and Add Some Real Estate To Your Portfolio.)

Gold
For thousands of years, investors have viewed gold as one of the best stores of value, and therefore one of the safest investments in the world. In times of crisis or market panic, investors often flock to the safety of gold, pushing its price higher. Furthermore, gold is traditionally considered a good inflation hedge and during times of inflation the price tends to rise. Despite these benefits, gold has not been an exceptional long-term investment and has suffered through lengthy periods of underperformance, which are generally followed by shorter periods of strong gains.

Nevertheless, gold may be an appropriate holding as part of a diversified portfolio focused on safety. However, it is important to remember that gold does not provide any income and is therefore not appropriate for investors interested in generating cash flow from their portfolios.

Investors have several options for purchasing gold. First, they can go out and buy physical gold in the form of bullion or gold coins. This approach has several disadvantages, including the need to store the precious metal and keep it safe. An easier approach is to purchase shares in an exchange traded fund (ETF) that tracks the price of gold. This provides exposure to the price of gold without the necessity of storing the underlying assets. The drawback is that the ETF will charge a management fee which will slightly reduce the investor’s total return on gold. A third method of tracking the price of gold is to purchase futures or options on gold; while this is an appropriate method for some investors, those most interested in safety should probably seek other alternatives. Finally, an investor can purchase the shares of companies involved in the gold industry. This method provides less direct exposure to the price of gold and is probably less desirable for investors interested in owning “real assets.” (See Does It Still Pay To Invest In Gold? to find out the merits of investing in gold.)

Collectibles
Collectibles such as silver, jewelry, art, or even stamps and comic books can all be considered real assets. Many of these assets may act as a store of value and provide safety to an investor’s portfolio while holding the potential for capital gains. However, most of these markets are highly specialized and investors should have a clear understanding of what they’re getting into.

Many of these collectibles are intended to be purchased as part of a hobby or for other intangible purposes. Therefore, individuals will face unique challenges when attempting to navigate these markets with the intention of making an investment. Some of these challenges include a lack of information, difficulty finding available inventory, a lack of reliable pricing data, high storage costs, and very large differences in the prices at which similar items can be bought or sold. Also, most of these assets do not generate any income. All of these factors contribute to make many collectibles inappropriate for the average investor.

If an individual is interested in collectibles as part of a hobby or for aesthetic reasons, and if the investment aspect is seen as a bonus, these assets may very well form a reasonable portion of a diversified portfolio. Likewise, if an individual has some unique advantage and presents an unusual ability to profit in these markets, they should certainly pursue that opportunity. However, the majority of investors should probably leave collectibles to those truly passionate about them and instead focus on more traditional asset classes. (Read Contemplating Collectible Investments to learn more.)

Conclusion
This chapter discussed real estate, gold and collectibles. Investing in these real assets poses unique challenges not faced in many other investment options. Investors should carefully consider these challenges before deciding whether to include real assets as part of a diversified investment portfolio. If, after carefully considering the challenges, investors do decide to purchase real assets, they will find that they often serve as an excellent store of value and as a hedge against inflation. As such, they could form a valuable component of a portfolio focused on safety of principal. However, gold and collectibles do not generate income, making them inappropriate for individuals interested in generating cash flow.

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When constructing a portfolio, the primary consideration is to build the portfolio that is most likely to help an investor achieve his or her financial goals. This optimal portfolio can vary greatly depending on an investor’s unique return objectives and risk tolerance. This chapter will discuss how an emphasis on safety and income can be integrated into the portfolio process to help an investor build an optimal portfolio.

Return Objectives
When building an investment portfolio, an investor must determine what it is that they are trying to accomplish. For an individual, this can be any one of many things. An individual may be investing to build a retirement portfolio, to purchase a new home or to build a rainy day fund. These objectives will carry with them different time horizons, which means that the optimal portfolio in each instance is quite different. When the time horizon is very long, such as for some retirement investment programs, a portfolio can be invested in a more aggressive manner. When the time horizon is short or the funds are intended to serve as an emergency backstop, an emphasis on safety becomes more important.

In addition to capital appreciation, a goal of an investment program may be to generate income to meet expenses. This is particularly true for individuals who are retired or who depend on their portfolios for ongoing income. For these individuals, income becomes an important consideration when structuring a portfolio.

Risk Tolerance
Perhaps the most important question an individual needs to ask when constructing an investment portfolio is: “what is my risk tolerance?” The combination of return objectives and risk tolerance will then determine the optimal portfolio and the optimal asset allocation. Again, time horizon plays an important role in determining risk tolerance. The longer the time horizon, the more risk an investor is able to take. The shorter the time horizon, the more cautious an individual should be in his or her investment approach.

The above discussion focuses on the ability to take risk, but there is another important consideration in determining risk tolerance. In addition to ability to take risk, investors should also carefully consider their willingness to take risk. These two factors are not always in alignment. For instance, an investor with a long-term goal may have the ability to take on additional portfolio risk, but if the thought of losing money keeps them awake at night they might not have the willingness to take much risk.

Investors should attempt to align their ability and their willingness to take risk. However, in situations where ability and willingness provide conflicting signals, investors should defer to that which is more conservative. In other words, if an investor has the ability to take risk but not the willingness, they should take less risk. On the other hand, even if an investor is aggressive by nature, if their objectives are short-term in nature, they should probably invest conservatively. (Learn more about this important topic in our article Risk Tolerance Only Tells Half The Story.)

Safety, Income and Growth
Safety, income and growth are the three main objectives within an investment portfolio. The degree of emphasis placed on each of these goals will differ depending on an individual investor’s return objectives and risk tolerance. Cautious investors will emphasize safety, while aggressive investors will emphasize growth. Likewise, investors who require cash flows from the portfolio will emphasize income while with no need for income will emphasize growth.

While the degree of emphasis on these three objectives will vary, under most circumstances investors should not exclude one. For instance, even in the most cautious of investment programs, attention should be paid to growing the portfolio enough to keep pace with the rate of inflation. Likewise, even aggressive investors with long-term time horizons should pay strict attention to risk management, as large losses in a portfolio can be difficult to overcome even over long time periods. Finally, regardless of whether an individual intends to withdraw cash from the account, income is responsible for a large portion of total return in investment portfolios over time; therefore, investors that ignore this crucial component do so to their own detriment.

Conclusion
In general, younger investors will have a reduced emphasis on safety and income while older investors will focus more closely on these goals. Likewise, individuals with short-term time horizons will primarily focus on safety while those with longer-term objectives will be interested in growing the portfolio. Importantly though, investors should seek to balance both safety and growth within the portfolio management process; the precise emphasis will vary depending on unique circumstances, but neither should be ignored. Finally, regardless of whether withdrawals are intended from the portfolio, income can help to produce superior total return in a portfolio over time.

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The first thing that comes to most people’s minds when they think of investing is the stock market. After all, stocks are exciting. The swings in the market are scrutinized in the newspapers and even covered by local evening newscasts. Stories of investors gaining great wealth in the stock market are common.

Bonds, on the other hand, don’t have the same sex appeal. The lingo seems arcane and confusing to the average person. Plus, bonds are much more boring – especially during raging bull markets, when they seem to offer an insignificant return compared to stocks.

However, all it takes is a bear market to remind investors of the virtues of a bond’s safety and stability. In fact, for many investors it makes sense to have at least part of their portfolio invested in bonds.

Just as people need money, so do companies and governments. A company needs funds to expand into new markets, while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).

Of course, nobody would loan his or her hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This “extra” comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you’ll get back if you hold the security until maturity.

For example, say you buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years. This means you’ll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you’ll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you’ll get your $1,000 back.

Debt Versus Equity
Bonds are debt, whereas stocks are equity. This is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder. However, the bondholder does not share in the profits if a company does well – he or she is entitled only to the principal plus interest.

To sum up, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.

Why Bother With Bonds?
It’s an investing axiom that stocks return more than bonds. In the past, this has generally been true for time periods of at least 10 years or more. However, this doesn’t mean you shouldn’t invest in bonds. Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market. Take two situations where this may be true:

1) Retirement – The easiest example to think of is an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income for it is required to pay the bills.

2) Shorter time horizons – Say a young executive is planning to go back for an MBA in three years. It’s true that the stock market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in stocks, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment.

These two examples are clear cut, and they don’t represent all investors. Most personal financial advisors advocate maintaining a diversified portfolio and changing the weightings of asset classes throughout your life. For example, in your 20s and 30s a majority of wealth should be in equities. In your 40s and 50s the percentages shift out of stocks into bonds until retirement, when a majority of your investments should be in the form of fixed income.

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Bonds have a number of characteristics of which you need to be aware. All of these factors play a role in determining the value of a bond and the extent to which it fits in your portfolio.

Face Value/Par Value
The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. Corporate bonds normally have a par value of $1,000, but this amount can be much greater for government bonds.

What confuses many people is that the par value is not the price of the bond. A bond’s price fluctuates throughout its life in response to a number of variables (more on this later). When a bond trades at a price above the face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.

Coupon (The Interest Rate)
The coupon is the amount the bondholder will receive as interest payments. It’s called a “coupon” because sometimes there are physical coupons on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept electronically.

As previously mentioned, most bonds pay interest every six months, but it’s possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10% and its par value is $1,000, then it’ll pay $100 of interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond. Another possibility is an adjustable interest payment, known as a floating-rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury bills.

You might think investors will pay more for a high coupon than for a low coupon. All things being equal, a lower coupon means that the price of the bond will fluctuate more.

Maturity
The maturity date is the date in the future on which the investor’s principal will be repaid. Maturities can range from as little as one day to as long as 30 years (though terms of 100 years have been issued).

A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond.

Issuer
The issuer of a bond is a crucial factor to consider, as the issuer’s stability is your main assurance of getting paid back. For example, the U.S. government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small – so small that U.S. government securities are known as risk-free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors – this is the risk/return tradeoff in action.

The bond rating system helps investors determine a company’s credit risk. Think of a bond rating as the report card for a company’s credit rating. Blue-chip firms, which are safer investments, have a high rating, while risky companies have a low rating. The chart below illustrates the different bond rating scales from the major rating agencies in the U.S.: Moody’s, Standard and Poor’s and Fitch Ratings.

Bond Rating Grade Risk
Moody\’s S&P/ Fitch
Aaa AAA Investment Highest Quality
Aa AA Investment High Quality
A A Investment Strong
Baa BBB Investment Medium Grade
Ba, B BB, B Junk Speculative
Caa/Ca/C CCC/CC/C Junk Highly Speculative
C D Junk In Default

Notice that if the company falls below a certain credit rating, its grade changes from investment quality to junk status. Junk bonds are aptly named: they are the debt of companies in some sort of financial difficulty. Because they are so risky, they have to offer much higher yields than any other debt. This brings up an important point: not all bonds are inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier, than stocks.

Bond Basics: Yield, Price And Other Confusion

Understanding the price fluctuation of bonds is probably the most confusing part of this lesson. In fact, many new investors are surprised to learn that a bond’s price changes on a daily basis, just like that of any other publicly-traded security. Up to this point, we’ve talked about bonds as if every investor holds them to maturity. It’s true that if you do this you’re guaranteed to get your principal back; however, a bond does not have to be held to maturity. At any time, a bond can be sold in the open market, where the price can fluctuate – sometimes dramatically. We’ll get to how price changes in a bit. First, we need to introduce the concept of yield.

Measuring Return With Yield
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.

Let’s demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

Yield To Maturity
Of course, these matters are always more complicated in real life. When bond investors refer to yield, they are usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).

Putting It All Together: The Link Between Price And Yield
The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice versa. Technically, you’d say the bond’s price and its yield are inversely related.

Here’s a commonly asked question: How can high yields and high prices both be good when they can’t happen at the same time? The answer depends on your point of view. If you are a bond buyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you’ve locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.

Price In The Market
So far we’ve discussed the factors of face value, coupon, maturity, issuers and yield. All of these characteristics of a bond play a role in its price. However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.

Bond Basics: Different Types Of Bonds

Government Bonds
In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories:

Bills –
debt securities maturing in less than one year.
Notes – debt securities maturing in one to 10 years.
Bonds – debt securities maturing in more than 10 years.

Marketable securities from the U.S. government – known collectively as Treasuries – follow this guideline and are issued as Treasury bonds, Treasury notes and Treasury bills (T-bills). Technically speaking, T-bills aren’t bonds because of their short maturity. (You can read more about T-bills in our Money Market tutorial.) All debt issued by Uncle Sam is regarded as extremely safe, as is the debt of any stable country. The debt of many developing countries, however, does carry substantial risk. Like companies, countries can default on payments.

Municipal Bonds
Municipal bonds, known as “munis”, are the next progression in terms of risk. Cities don’t go bankrupt that often, but it can happen. The major advantage to munis is that the returns are free from federal tax. Furthermore, local governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds completely tax free. Because of these tax savings, the yield on a muni is usually lower than that of a taxable bond. Depending on your personal situation, a muni can be a great investment on an after-tax basis.

A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years.

Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company’s credit quality is very important: the higher the quality, the lower the interest rate the investor receives.

Other variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.

Zero-Coupon Bonds
This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let’s say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you’d be paying $600 today for a bond that will be worth $1,000 in 10 years.

Bond Basics: How To Read A Bond Table

Column 1: Issuer – This is the company, state (or province) or country that is issuing the bond.

Column 2: Coupon – The coupon refers to the fixed interest rate that the issuer pays to the lender.

Column 3: Maturity Date This is the date on which the borrower will repay the investors their principal. Typically, only the last two digits of the year are quoted: 25 means 2025, 04 is 2004, etc.

Column 4: Bid Price – This is the price someone is willing to pay for the bond. It is quoted in relation to 100, no matter what the par value is. Think of the bid price as a percentage: a bond with a bid of 93 is trading at 93% of its par value.

Column 5: Yield – The yield indicates annual return until the bond matures. Usually, this is the yield to maturity, not current yield. If the bond is callable it will have a “c–” where the “–” is the year the bond can be called. For example, c10 means the bond can be called as early as 2010.

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The Retirement Trap Copyright © by Bill Babcock and Babcock, William. All Rights Reserved.

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