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Understanding Fixed Income Securities

Kevin Connor
Feb 6, 2017
When people talk about the market, they tend to think about the Standard and Poors 500 or the Dow Jones Industrial Average, but there is another side to successful investing. Fixed income securities serve a vital purpose in a client's portfolio, and it is important for financial professionals to assess the needs of their investors and guide them toward the most suitable investments.

As with other kinds of investments, the purpose of, and need for, fixed income securities often change over time. A young worker with decades to go before retirement may be comfortable allocating 100% of their investment resources to the stock market, while a new retiree may prefer a more balanced approach. From those two extremes to everywhere in between, the job of the financial advisor is to balance risk, assess the needs of the client and design a portfolio that maximizes return while protecting principal.

The Impact of Interest Rates

Perhaps the most important thing clients should keep in mind is that interest rates and bond fund prices have an inverse relationship. This is not a matter of opinion or spin - it is simple math.

When interest rates rise, net asset prices on bond prices can be expected to fall. The severity of the decline will depend in large measure on the average duration of the fund - the longer the duration, the steeper the decline will be. That is why many financial advisors recommend keeping durations relatively short in an environment of rising interest rates.

Of course, there is a potential upside to rising rates. As interest rates rise, the amount of income generated by quality bond funds should go up as well. As a financial advisor or wealth manager, part of your job is helping clients understand the risk/reward ratio inherent in bond fund investing.

Individual Bonds vs. Bond Mutual Funds

The net asset values of bond funds can be expected to decline in response to rises in interest rates, and that can make bond funds riskier than individual bond investing. For high net worth clients and those with specific needs, investing in individual bonds can make sense, but those bonds must be chosen with care.

Some individual bonds, like those issued by the U.S. government, are virtually risk-free, while others, issued by struggling companies in an attempt to stay in business, carry a very high level of risk. That is why even seasoned investors often seek professional help and guidance when navigating the tricky waters of the individual bond market.

Despite the inherent risk, holding individual bonds does have a significant upside. While selling a bond mutual fund in a rising interest rate environment could mean taking a loss, holders of individual bonds can simply collect their interest and wait for the bonds to mature. No matter what the ultimate decision, it is important that your clients understand the differences between individual bond holdings and investments in bond mutual funds.

The Two Main Kinds of Fixed Income Investing Risk

Every type of investment, including fixed income investments, come with some inherent risks. As a financial advisor or wealth manager, a big part of your job is helping clients understand and quantify these risks.

There are two main types of risks associated with bond market investments, and it is important your clients assess and understand each one of them. The most obvious, and most visible, type of risk is interest rate risk, a topic that has been discussed in greater detail earlier in this article.

Simply put, when interest rates rise, the net asset value of a bond mutual fund can be expected to decline. Many new fixed income investors do not fully appreciate this risk, and they may be taken by surprise as a result. If you have clients who are new to bond investing, a thorough explanation of interest rate risk and its implications can help you avoid unpleasant surprises down the road.

Credit risk is another seemingly obvious but often underappreciated risk associated with fixed income investing. When you, or your clients, buy a bond, they are essentially making a loan to the entity in question. Whether that entity is a corporation, a school district or the Federal government, the concept is largely the same.

In exchange for the promised interest rate, the individual buying the bond, or bond fund, agrees to lend the entity money. When you buy an individual bond or bond mutual fund, you trust that the interest payments will be made on time and that you will get your money back when the bond matures. That makes the creditworthiness of the company or institution a key concern, and it is up to financial advisors and wealth managers to make a wise choice.

A Stabilizing Force on the Portfolio

There are many reasons to include fixed income securities in a client's portfolio, and the kinds of investments will be directly tied to the forces behind their inclusion. The worker in the prime of their earning years may use fixed income investments to balance the risk in their portfolio. In that case, those bonds and bond funds will serve as a stabilizing force on the portfolio. Instead of introducing new kinds of risk through high-yield bonds and long-duration bond funds, financial advisors can guide their clients into short-duration bond funds, high-quality individual bonds, and government bond portfolios.

Others investors may have different reasons for including fixed income securities in their portfolios. New retirees may be looking for an additional source of income and a way to replace that lost paycheck. In that case, an experienced financial advisor might recommend a portfolio comprised of individual bonds, top quality bond funds and even certificates of deposit.

High earners may see their fixed income portfolios as a way to avoid confiscatory taxation. In that case, their financial advisor or wealth manager may design a portfolio of tax-free municipal bonds and similar securities. No matter the reason for investing in fixed income securities, an experienced advisor will help their client develop a portfolio that makes sense for their needs and lifestyle.

Fixed income investments have a place in many portfolios, and helping your clients navigate the world of bond market investing is a key part of your role as a financial advisor or wealth manager. Whether your clients are in their prime earning years or already dreaming of a prosperous retirement, understanding fixed income investments, and the associated risks will serve them well.

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