RICHARD LEHMANN is President of Income Securities Advisors, Inc. (ISA), and publishes the Forbes/Lehmann Income Securities Investor newsletter, as well as the ETF Investor Newsletter and Distressed Debt Securities Newsletter. He founded the Bond Investors Association (BIA) in 1983 as an information and advocacy organization for individual bondholders. ISA is the successor to BIA. Lehmann is also a columnist with Forbes magazine and has been actively involved in fixed income advising and bond defaults since 1976. He is also the portfolio manager of the Fallen Angels Income Fund (FAINX), a publicly traded no-load fund. Lehmann has taught finance and accounting in Miami and has spoken at numerous investment seminars. He holds an MBA from Columbia University, is a CPA, and an SEC-registered investment advisor. Visit www.incomesecurities.com for more information.

Income Investing Today

Safety & High Income Through DiversificationBy Richard Lehmann

John Wiley & Sons

Copyright © 2007 Richard Lehmann
All right reserved.
ISBN: 978-0-470-12860-2

Chapter One

The Why and How of Fixed Income

Why Consider Fixed Income?

Growth versus Income (Stocks versus Bonds)

Experts have been saying for years how much better stocks have been in providing long-term profits than bonds. Depending on which study you read, stocks have returned an estimated 7 to 11 percent a year for the past 100 to 200 years. Bonds, on the other hand, are credited with returns of just 2 to 4 percent, again depending on the study. The obvious conclusion the investor is supposed to draw from these studies is that a choice between stocks or bonds is a no-brainer. Why, then, are the fixed-income markets several times bigger than the stock market? Why do many more investment dollars go into bonds and preferreds rather than stock? There are many ways to answer this question, and in those answers, you may just find your reason for considering fixed-income securities.

The principal reason fixed-income securities have faired badly in these studies is inflation. Inflation has historically sapped anywhere from 20 percent to more than 100 percent of the return paid by bonds. While this remains a perennial weakness of fixed-income securities, it has become less so over time. The ravages of inflation are much better understood today by those in government whose responsibility is to control it. More important, the tools for controlling it are in place and not as vulnerable to the political forces of the day. Another reason for the poor showing for bonds is that such studies used U.S. Treasuries as the fixed-income benchmark. While this is the premier bond instrument in the world, it is hardly representative of the fixed-income universe. Because of its high quality, it is easily 1 to 4 percent below most other debt instruments in its rate of return. Today’s bonds and preferreds offer an array of risks and yields for which no historic equivalent exists for comparison. This book focuses on many of these investment instruments, many yielding relatively low-risk returns of 8 percent or more.

A second consideration in evaluating stock-versus-bond studies is volatility. The returns cited for equities include years in which they were as much as plus or minus 20 percent. Additionally, within any given year, price fluctuations of plus or minus 50 percent are not uncommon. Hence, any given investor, depending on when and how much he or she invested, could average less than half or more than twice the 7 percent return rate, which has been cited by studies as a long-term average. Buying into a mutual fund can mitigate some of the intrayear volatility, but not the interyear volatility. Bonds, on the other hand, have only a fraction of this volatility. In fact, you control much of it by virtue of how long a maturity date or credit quality you select.

With stocks, the investor is putting his or her future into the hands of company managers whose skills, priorities, and loyalties are constantly shifting and open to question. While high salaries and generous options are given to them to ensure loyalty, this has proven only partially successful and may serve to encourage risk taking beyond their management skills in order to enhance stock prices. With bonds and preferreds, investors are insulated against most mismanagement unless it proves fatal, but even then, they stand ahead of shareholders in being repaid in any corporate reorganization or liquidation. Investing via a mutual fund further removes the investors’ control over their funds, since now the judgments and priorities of the fund managers are a factor as well.

Looking forward, I doubt whether past history is the best way to predict future performance. The principal reason for this is that past stock performance was in large part due to high dividend payments. According to a recent study by Robert Arnott and Peter Bernstein in the Financial Analysts Journal, as much as 5 percent of the 7 percent historic return for stocks came through dividend yields. During the 1990s this percentage dwindled to 1.5 percent. This is one of the unintended consequences of management stock options. Since stock options become valuable through price appreciation, not dividends, profits are going to be used either to buy back shares or launch new ventures, no matter how marginal. The study went on to note that only 1.4 percent of the 7 percent historic return came from earnings growth. Since economic growth has been over 2 percent for most of this century, it means public companies are not keeping pace with the economy as a whole. Hence, the money retained by corporations got a poorer return for investors than the 5 percent that they distributed. What then can we expect now that dividend payouts have slipped to only 1.5 percent? Although recent tax law changes have made dividends more attractive, increases in dividend payouts have been slow to gain momentum, which has not been helped by the fact that the tax law change is set to expire in 2010 unless extended by Congress.

The main reason, though, why bonds will continue to outsell common stocks is that they reflect the wisdom expressed best by Ben Franklin: “A bird in the hand is worth two in the bush.” Fixed-income securities offer a definite rate of return and a definite date in the future when they will return a definite amount owed. These are, or should be, of ever-increasing importance the closer one gets to retirement.

Selecting stock investments differs from selecting a fixed-income security in one critical respect. In order to profit in stocks, the company must prosper. Not so for fixed income. To make money in fixed-income investments, the company need only survive. Making a judgment about a company’s ability to prosper is often extremely complex, because it is so dependent on such intangibles as the general economy, the legal environment, industry trends, management ability, and just plain good luck. Judging a company’s ability to survive is more dependent on data and much less dependent on intangibles. Learn how to understand the data and you’ve learned how to invest.

Understanding the data, however, does require learning how to interpret it. This is not to say that the intangibles affecting stocks don’t also affect bonds, but rather that the effect is generally not as severe and takes place over a longer period of time.

What Kind of Investor Are You?

You may have picked up this book precisely because you don’t know the answer to this question. Hopefully, you will be able to answer it before you are finished reading. The question usually comes up because many individuals fail or even resist putting themselves into a defined category. Yeah, I’m unique. But I haven’t saved enough for my retirement, and I’m getting close enough to retirement to worry, and I don’t have a clear plan for saving or a clear investment strategy, and I don’t even know how much I’ll need to retire, and my present investments are going nowhere. Sure, you’re unique, but maybe you can find your spouse or an anonymous friend in the following investor types.

The first and most common investor species is the buy and hold investor. These investors buy good, safe things like Treasuries, munis, CDs, money market funds, and investment-grade bonds. They want to sleep well at night, so they take no risks. They also get a lousy rate of return. Ideally, we’d all like to be so blas about investing, but most of us don’t have enough resources to afford that, as evidenced by the fact you are reading this book. (Just kidding!)

The second investor type is the total return investor. These individuals want to grow their portfolio by both income and capital appreciation and have no current urgency for cash income. They have a broader array of investment choices and a bit higher risk tolerance level. They are generally still working full-time and growing their portfolio as much by new savings as by portfolio growth. This group will get the most benefit from this book.

The third type of investor is the scared investor. These individuals are scared of any risk, probably because of bad personal experience, or they are scared because they haven’t a clue about investing. This group is the most sought after by financial industry people because they can be talked into buying the most expensive or risky investments. They buy mutual funds and whatever else a broker can talk them into because they won’t take the time or effort to learn investment fundamentals such as are found in this book. I can help scared investors if they are willing to learn, because mentally they have the most important attribute an income investor can have-fear.

The fourth type of investor is the desperate investor. These people know they are way behind in planning for their retirement and are looking to hit a home run to catch up. They differ from the scared investor in that they think they know what they’re doing because they’ve had some successes in the past. What they’ve really had in the past was a smattering of luck and selective memory. The fact that they’re desperate means their luck comes only now and again. If you are one of these investors, you are beyond my help. Return this book to where you bought it and ask for your money back. And this time, I’m not kidding!

It’s not my goal to fit everyone into my formula for income investing. You need to develop a strategy with which you can be comfortable for years or even decades-one that can succeed across different business cycles and financial downturns. If you learn the fundamentals detailed in this book, I’m sure a more confident you will emerge. And that new you will become a more successful income investor.

Investment Strategies

Asset Allocation

How many investors can tell you what their asset allocation is? For that matter, how many investors can tell you what asset allocation is? To appreciate the importance of this investment basic, let’s first define it. Asset allocation is how you distribute the discretionary portion of your net worth among various categories of assets. By discretionary portion, I mean the assets that you own and that you could reallocate without having to change your lifestyle. The easiest system consists of the following six categories:

1. Cash. Includes CDs and money market funds. 2. Fixed-income securities. Includes bonds, preferreds, and convertibles. 3. Common stocks. Includes all equities in public companies or in mutual funds. The family business is not included. 4. Collectibles. Includes art, gold, diamonds, postage stamps, coins, and other tangible assets with an investment value. 5. Real estate. Includes only your nonresidential real estate. 6. Other assets. Includes partnership investments, tax shelters, and any asset you hold that is not part of your lifestyle or business.

It is a worthwhile exercise for everyone to take the time to list their asset holdings under each of the preceding six categories. Exact values are not important at this stage-just be sure you count everything.

Once you have completed this exercise, determine what percentage of the whole (100 percent) each category represents. Let’s evaluate the results. Add up the dollar amount of categories 1, 2, and 3. These are the assets that can provide you with a steady retirement income. Multiply the dollar value by 7 percent (a theoretical rate of return and drawdown of your capital that can be maintained over a normal life expectancy) and ask yourself whether the resulting amount is sufficient, when added to your pension benefits, to supplement the income you expect to need when you retire. If not, then look at categories 4, 5, and 6 and ask yourself which of these you should consider selling in order to increase your income. Too often, we find ourselves holding assets in the 4, 5, and 6 categories that we inherited or purchased for reasons that no longer matter. This is not the time to be sentimental, unless you can afford it.

The Right Allocation for You

The right answer to the allocation question is clearly personal (i.e., the combination that will help you achieve your investment goal). If you are a 55-year-old baby boomer who has not saved enough to retire comfortably by age 67, you may be tempted to allocate 100 percent to stocks in hopes of catching up. As I point out later in the chapter, under “Retirement Planning,” this is not the time in your life to test your luck, because you have little room to err. If you are well along in saving for your retirement, and all future appreciation will only fatten the estate you will leave behind, then you have room to take a heavier stock position. My advice to someone 55 or older who needs to catch up is, start with a 50/50 (stock/income) allocation and reduce the stock allocation by 1 percent each year, so that by age 67 your allocation will be 38/62. This approach may or may not work for you. An important consideration here is your comfort level with whatever strategy you pursue. Keep in mind, however, that finding comfort through buying one or more mutual funds is not a sound strategy for reducing stock market risk. More on this later.

Diversification

Diversification is easily the most important subject in income investing. When you bring up the subject of diversification to an audience of fixed-income investors, they tend to think of traditional mantras such as the following:

Don’t investment too much in any one security or issuer or industry. Spread your investment among different rating qualities and instruments Ladder your maturities.

These guidelines are meant to help investors minimize their exposure to loss from defaults, credit crunches, and inflation. In principle, these traditional guidelines are inherently good ideas, but much too limiting for today’s investing climate. The problem with them is that they are basically defensive in scope. They assume fixed-income investors must constantly protect against declines in the value of their portfolio, since, with traditional fixed-income instruments, the par value and maturity of the instrument limits any upside appreciation while downside risks are limitless.

Looking at these diversification guidelines in greater detail, well, yes, it’s never a good idea to have too large a stake in the fortunes of any one company. Generally, 5 percent is a good upper limit on any one security or issuer. Such a policy, however, makes no exception for special-situation investments, which I cover later in this section. Diversification by industry makes sense only because the market is irrational. Right now fixed-income investments in the auto industry are taking a beating, in part because it is receiving so much bad press. Fixed-income investors often run from an industry when this occurs, even though the doom and gloom the media is talking about falls almost exclusively on shareholders and not on debt holders. This is a downside risk for income investors mainly because any eventual good news gives little upside boost to a company’s debt until the whole industry turns around.

Spreading risk among different rating qualities is an attempt to offset the dismal returns on A- to AAA-rated issues by blending in some BBB and BB issues. As I explain later in the chapter under “Credit Ratings,” all that investors should be concerned with is getting their interest payments on time and recovering their principal at maturity. Only if there is reasonable doubt about a company’s survival should investors be concerned with the credit instrument and its terms (i.e., how senior is the debt, what is the collateral, and which debt issues are first in line if the company does go bankrupt?).

Laddering maturities is a strategy that spreads your maturities over short-term and longer-term issues so that in the case of any interest rate spike you take a lot of little hits instead of one big one. It also provides a continual cycle of maturing issues that can then be reinvested at current interest yields. The flaw here is that when the interest rate yield curve is flat or negative, as it is at the time of this writing, you get no premium yield for buying longer maturities. Laddering makes sense mainly if your selection of maturities coincides with your expected drawdown of the funds involved (i.e., if you plan to spend everything as it matures).

(Continues…)

Excerpted from Income Investing Todayby Richard Lehmann Copyright © 2007 by Richard Lehmann. Excerpted by permission.
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