What is the Fixed Income asset class? Why invest in fixed income, such as bonds and preferred shares? How does the phase of your life cycle, personal circumstances, and risk tolerance affect your target asset allocation to fixed income?
Fixed income issuers often attach special features, usually called “sweeteners”, to make an issue more attractive to investors. If you want to learn about a few common features, please read, “Key Bond Features: Part 1” and “Key Bond Features: Part 2”.
“How should those in the Accumulation phase of life assess fixed income portfolio allocations?”
Accumulators are relatively young, just starting their careers. With little wealth to invest, what should they allocate to fixed income?
Given that Accumulators tend to have longer time horizons and can handle asset volatility, then relatively lower volatility fixed income, with its low-return, may not be best allocation. At least for the assets not targeted to shorter term objectives.
While fixed income is currently useful for its diversification benefits combined with equities, a heavy allocation here for Accumulators is usually not warranted. But, as we will see below, other factors may arise that make relatively more fixed income prudent.
“What about Consolidators? How is fixed income for them?”
Consolidators are in the sweet spot of their earnings and careers. With a relatively long time horizon until retirement, there is still no real need to shift into low-risk, stable assets.
Again, fixed income is more a diversification tool than an investment to generate returns. That said, in times of falling interest rates, fixed income can offer some very healthy returns.
There may still be a role for shorter term objectives, where they do want that certainty and liquidity. As well, as Consolidators approach retirement age, then adding to the fixed asset allocation may make sense.
“What sort of fixed asset allocations for Spenders?”
Spenders are at, or near, retirement. They rely on pension income, supplemented by cash flow from investments. At this phase of life, there is more interest in stable, liquid investments. Like fixed income.
The problem for Spenders is that people continue to live longer. Investors used to allocated 80-90% in fixed income and cash equivalents upon retirement. But that assumed retirement at 65 and life ending at 72. Fine if there is only 7 years remaining.
People now often live into their 90s. If your time horizon is 30 years, trying to do so with a 90% fixed income portfolio may be difficult. You likely want to still invest in higher risk (higher return) equities as you need to grow your assets. As well as to keep ahead of inflation, which often ravages fixed income yields. For today’s 65 year old investors, 30-40% in fixed income might be warranted. Then slowly adjusted upwards as the years pass by.
“What about personal circumstances and its impact on allocations?”
Identical issues as with cash.
Everyone is in a different situation. That will impact the optimal fixed income asset allocation.
Perhaps you require a fixed amount monthly for living expenses. Or have health issues that need to be addressed. Your personal status will determine, to some extent, what you need in monthly net cash inflows and asset safety. In turn, that will dictate the asset allocation and specific investments to best meet that cash flow requirement. In interest or dividends. Or possibly in an annuity.
“And investor risk tolerance? Does that affect the target asset allocation?”
Your personal risk tolerance also guides your investment decisions.
Some young investors prefer no allocation to fixed income. They want all their capital invested in higher return assets. The benefits of diversification are less important to them than higher expected returns. With long time horizons to manage volatility, this may be reasonable. But likely less than an optimal portfolio should hold.
Conversely, other investors may prefer safety and stability in their portfolios, regardless of age and personal situation. Again, their risk tolerance may create a desire for more fixed income than is optimal.
In most cases, risk tolerance is more emotional. Based on factors such as personality, past experience, etc. Much less on taking a purely ration approach to risk management. To refresh on investor risk issues, please refer to “What is Your Risk Tolerance?” and “Investor Profiles”.
As with cash, there are some generalizations that are useful for investors to factor into their own target asset allocation. But there are also unique, personal aspects that will alter that general allocation.
That is why it is crucial for investors and/or their financial advisors, to develop comprehensive Investor Profiles before beginning the target asset allocation. The unique circumstances of the investor must be factored into the allocation equation. Otherwise, a poor investing plan will be created.
In Asset Allocation: Fixed Income (Part 1), we quickly reviewed fixed income as an asset class. We then considered fixed income allocations for Accumulators. Finally, we saw how fixed income can provide excellent diversification benefits within a portfolio. Asset correlations between, and within, asset classes, being so important.
Consolidators are older, but still have lengthy time horizons in which to invest. Consolidators should have some wealth accumulated and their investments in cash equivalents will reflect this. Perhaps 5-10% of total assets will be in cash.
Not the Best, But Not Bad
Because of the relatively long time frame, fixed income should not dominate the portfolio. Rather, the focus should be on investments with greater capital growth potential.
Same as with Accumulators.
Becomes Better With Age
As the time to retirement shrinks, Consolidators should increase their allocation to fixed income. This will solidify previous accumulated portfolio gains, reduce overall portfolio risk, and begin to generate stable income flows for retirement.
But not too much, as we shall see below.
The Magic Number
For the generic Consolidator, 10%-30% allocated to fixed income may be appropriate. The increase from the Accumulation phase simply reflects a reduction in necessary cash equivalents to about 5%. The suggested allocation also takes into account that Consolidators often invest in alternative asset classes.
One’s risk tolerance will determine the appropriate allocation. If you are extremely risk averse a higher percentage allocated to fixed income may be appropriate. It is your portfolio. You need to be comfortable with your investments. Because it is also your (potential) ulcer.
Finally, the extent that you invest in non-traditional investments (e.g., derivatives, commodities, venture capital, etc.) will impact your ultimate allocations.
The wider you spread your investments, the less that is usually allocated to any one class. How you diversify your portfolio will depend on your investment knowledge, comfort level, risk preferences, asset correlations, and the like.
Fixed Income for Spenders
Spenders are usually individuals at retirement age. Employment or business income has ceased and Spenders need to live on their pensions and savings.
Spenders are generally risk averse. This reflects the reduced time horizon for surviving asset volatility.
Because of this, Spenders traditionally invest primarily in fixed income and cash equivalents.
Now We Are Talking
These asset classes provide the stability, consistency, and liquidity, Spenders want.
Many Spenders invest 80-90% of their wealth in cash and fixed income.
However, the trade-off for low risk investments is a low return. And that is a problem.
Too Much of a Good Thing
Today, many people retire between 55 and 65. Yet many retirees now live until at least their 80s. That means Spenders may need to live off their savings for 25 years. Often, much more.
That is a long time to survive on investments with low returns.
With longer lives (and investment time frames), Spenders should strongly consider maintaining a portion of assets in investments with potentially higher returns.
I would suggest that investors do not allocate 80% to cash and fixed income. Keep a portion in equities and other asset classes with better expected returns.
The Magic Number
At retirement time for the generic Spender, perhaps 30%-40% in fixed income is suitable. That assumes about 10% in cash equivalents at that date.
As one continues to age, additional assets should shift into cash and fixed income instruments.
Personal factors need to be taken into account. Theses include: health situation; family history of death age; wealth accumulated; cost of living; prevailing interest rates.
If you expect to live until 110, you need to plan for that in your investing and drawdowns.
If your accumulated wealth is high, you can take a safe investment path. But if you have not saved enough for retirement, you may want or need to try and generate greater returns with riskier assets.
If interest rates are low, your level of income will also be low. If it is insufficient to cover your mandatory costs, you may also need to try to boost returns with higher risk investments.
However, higher risk means increased volatility and possibility of loss.
Where you are at retirement will play a significant role in your actual asset allocation.
Your Personal Risk Tolerance Impacts Allocations
And, as is always the case, your personal risk tolerance plays a part in the allocation. When you retire, as well as how you reallocate during your retirement years.
Most Spenders should have relatively low risk tolerance. This reflects the lack of other income on which to live and the reduced investment time frame.
But some Spenders may be extreme and want almost everything invested in safe investments. They will sacrifice some income in order to sleep well at night. Other investors with higher risk tolerances may ignore the shorter time horizon and still want a significant portion of their assets in less stable investments.
Whether you are an Accumulator, Consolidator, or Spender, one size never fits all in a specific phase of life. There may be general rules of thumb. But each allocation should be tailored expressly for your own unique circumstances.
Fixed income is generally higher risk and higher return than cash equivalents. But it has a lower level of risk and expected return than common shares. Fixed income may be sought by relatively risk averse investors.
People who desire a constant stream of income liked fixed income. Though one can also buy zero coupon bonds.
What about the suitability of fixed income for those in the different phases of the life cycle?
Fixed Income for Accumulators
Not Really Suitable Investments
The logic goes that Accumulators tend to be young, with extremely long investment horizons. As a result, they can better absorb the fluctuations of higher risk and higher return investments than those in other phases of life. Because of this, Accumulators tend not to emphasize lower risk fixed income in their portfolios.
I agree with this logic.
Unless extremely risk averse, Accumulators should not invest heavily in fixed income assets.
But Do Not Exclude Completely
But that does not mean they should be totally excluded from one’s portfolio. Fixed income investments may provide diversification benefits with other asset classes.
For example, consider a few current inter-asset correlations. I will use data from Portfolio Visualizer as at March 15, 2019.
The current 10 year correlation between 20 Year U.S. Treasury Bonds (i.e., fixed income) and various traditional equities are: U.S. Large Cap Stocks −0.47; U.S. Mid Cap Stocks −0.46; U.S. Small Cap Stocks −0.45; International (excluding U.S) Stocks -0.43; Emerging Market Stocks -0.38.
If you recall our discussion of correlations, combining two assets with negative correlations is very beneficial in reducing portfolio risk. And any correlation below 1.0 (perfect positive correlation) improves overall portfolio efficiency. But the lower, all the way to -1.0 (perfect negative correlation), the better for diversification of portfolio risk.
When we look at alternative asset classes, we shall see that fixed income can also enhance diversification. Consider the latest 10 year correlation between 20 Year U.S. Treasury Bonds and: U.S. Real Estate −0.22; Commodities -0.22; Gold 0.17. Once again, fixed income can aid in portfolio diversification with alternative assets.
Do not forget that within the asset class itself, various subclasses may provide diversification benefits too. For example, the correlation between the 20 Year U.S. Treasury Bonds and U.S. Municipal Bonds is only 0.37. So there is still value in diversifying within the asset class.
Of course, you also need to factor in asset risk (standard deviation) and expected annual return in your portfolio calculations. Adding a high risk, low return asset to your portfolio simply because it has a low correlation may not be wise.
The Magic Number
Accumulators should include a percentage of investable assets in fixed income. For diversification, if for no other reason.
Also, fixed income may be a good place to park cash as financial objectives approach. You may tolerate high volatility in equities for retirement 30 years away. But perhaps you need a down payment on a new home in 6 months. Shifting assets to cash or lower risk bonds may be the wise move as objective due dates approach. When you seek certainty and safety over potential return and risk.
However, parking assets in cash or bonds for near term objectives should not reflect your general target asset allocation.
Another consideration for Accumulators may be zero coupon (aka strip or deep discount) bonds. Little or no interest is paid out. But you are able to buy an asset, with a known future value, with very little money. And very little money is common for Accumulators.
For example, a 30 year zero coupon bond yielding 3.0%. You can purchase a $100,000 bond for about $41,000. Not bad if you do not need the cash flow until retirement. The higher the interest rates and longer the term, the lower your outlay. A $100,000 zero coupon, 40 year bond at 5.5% would only cost about $12,000.
That longer time horizon is why zero coupon bonds may be better for Accumulators than older investors.
There are pros and cons to zero coupon bonds. Big con is no interest payments, yet you may still be liable for tax on the deemed interest income each year. If investing, do so in a tax-deferred or tax-free investment account. Also, you need to consider future inflation. At current 3.0% yields, given historic inflation rates, your real return over time with a zero coupon bond may be poor (or worse). But perhaps at 5-10% rates, these bonds become a nice addition to your portfolio.
Most Accumulators should not invest more than 50% of their investable assets in fixed income. I likely would not recommend 50% in fixed income even after backing out one’s cash equivalent component. The time horizon for most Accumulators is so long that investing in riskier assets, with higher long-term expected returns, makes more sense.
For the generic Accumulator, I might recommend somewhere between 5%-25% in fixed income. This assumes someone with a moderate risk tolerance and whose cash component, as a percentage of total wealth, is roughly 15-20%.
It also assumes that the fixed income itself is diversified. Which should be done when investing in any asset class.
Where you fall in this range will depend on your risk tolerance and amount invested in cash.
We shall break here for today. Next week, a look at fixed income allocations for Consolidators and Spenders.
In many ways, preferred shares act like fixed income. As with bonds, preferred shares may incorporate many different features, creating different types of shares.
Most of these are almost identical to the bond variants we looked at here and here. In fact, for any not listed below, you can look back at the bond features posts for further preferred share possible combinations.
Straight Preferred
These are your plain, vanilla preferred shares. The pay a fixed dividend rate and trade in the open market on a yield basis as if they were a bond.
For example, XYZ company issues 5.5% Cumulative Series H Preferred Shares at $25 per share. If comparative interest rates increase, the share price will fall to provide investors with the market yield. If general interest rates decrease, the share price will rise to again reflect the market returns.
Variable Rate Preferred
Also called “floating preferred”. These preferred shares are exactly the same as variable rate bonds. They pay a dividend that fluctuates with changes in interest rates.
For example, on January 1, 2017, ABC company issues Cumulative Series R Preferred Shares. These shares pay an annual fixed dividend of $2.00 per share until December 31, 2019. Beginning January 1, 2020, the dividend rate will float at a rate of 70% the average US prime rate of interest.
As with bonds of the same name, corporations normally include interest rates maximums and minimums to protect both themselves and shareholders from significant increases or decreases in interest rates.
Convertible Preferred
Like convertible bonds, the investor has the option to convert the preferred stock into another class of shares at a fixed priced within a specified date or period. Normally the option is to convert into the company’s common shares.
Because of the embedded option, a convertible preferred share will be priced somewhat higher than an equivalent straight preferred share. The premium paid by investors is the value of the embedded option.
The market value of straight preferred shares fluctuates based on general interest rate levels relative to the dividend paid. Convertibles though, are also affected by the market value of the shares that the preferreds may be converted into.
For example, each Convertco Cumulative Series B Preferred Share is convertible into 1.2 common shares of Convertco. On July 5, Convertco common shares traded at $20.50. At this price, the preferred shares would be worth $24.60 simply on the conversion factor alone ($20.50 * 1.2).
This would be the minimum value based on potential conversion. Because of the attached dividend, the preferred shares would actually be worth more.
As you pay a premium for the shares, you should believe in the underlying growth potential of the common shares. If not, then stick with straight preferreds and receive a higher yield on the dividend receipts.
Participating Preferred
Convertible preferreds provide the potential to capitalize on the growth of the issuing company. If the company grows and its common shares increase in value, you can convert your preferred shares to common shares (assuming that is the correct class) and benefit from the upside potential.
And, as we saw above, if the common shares have already increased in value, there will be a relative price increase to the preferreds as well, based on the conversion factor.
Participating preferreds also allow investors to benefit from the company’s success. In this case, it allows the preferred shareholders a right to a certain level of the company’s net earnings above the specified dividend rate.
This participation in the company’s net earnings comes in the form of a supplemental dividend, in addition to the normal payment. Often this is tied to the payment of dividends to common shareholders.
For example, Profitcorp has enjoyed a record year of earnings and cash flow. They are easily able to pay the dividends to holders of Profitcorp’s 10%, $25 Par Value, Cumulative Participating First Preferred Shares. With excess cash, Profitcorp decides to pay a $2.00 dividend to its common shareholders as well.
Under the terms of Profitcorp’s First Preferred Shares, any dividends paid to common shareholders must also be paid to holders of the First Preferred Shares at a rate of 50%.
In addition to the normal dividend of $2.50 (10% of 25 par value) received by the preferred shareholders during the year, they would also receive an incremental dividend of $1.00 (50% of $1 common share dividend).
As to the amount of extra dividends or the conditions for eligibility, one needs to review the relevant share documents.
Redeemable Preferred
Another one that we saw with bonds. Here the company holds an embedded call option on the shares. This allows the company to redeem some or all of the shares within a specified period of time.
If the company redeems the shares on a gradual basis, they usually utilize a “sinking” or “purchase” fund to do so.
As the company holds the option, they must pay for their privilege. As a result, the company will pay investors a premium for this option.
For example, in 2010, Callco issued 8% Cumulative Redeemable Series F Preferred Shares with a par value of $25. The shares were redeemable by Callco at $28 until December 31, 2015, $26.50 until December 31, 2020, and at par thereafter.
As you can see, if you owned shares that were redeemed in 2014, you would receive a $3 premium on each share ($28-25). But with the passage of time, the premium falls to $1.50 from 2016 through 2020, and then is zero after 2020.
Many companies issue redeemable shares. In part, because preferred shares often do not have a maturity date like bonds.
If a company wants to retire its debt, it can simply wait to maturity and then repay the principal. Of course, companies can utilize callable or redeemable bonds as well.
Minus any features, preferred shares cannot be cancelled except through repurchases on the open market. This can be expensive and may not result in being able to purchase and retire as many shares as the company desires.
Retractable Preferred
These give the shareholder the option to sell the shares back to the company at a specified price within a specified period.
As the option to sell now lies with the shareholder, there is a premium paid by the shareholder for this right.
Typically, if the retractable preferreds are not converted within a maximum time frame, they convert back to straight preferred shares.
That should provide a sense of what preferred shares are.
It should also illustrate why many consider them to be more debt than equity.
Next up, we will look at individual investments most of you own. Common shares or equity.
Although a form of equity, I generally consider preferred shares as fixed income. The characteristics of preferreds make them more like debt than equity. For asset allocation purposes, I normally include preferred shares with fixed income.
So what exactly is this hybrid asset that lies somewhere between debt and equity?
Ownership in the Company
Preferred stock is a means of ownership in a corporation. As part of a company’s ownership structure, preferred shares are part of shareholder equity on the balance sheet.
This differs from debt instruments which are merely loans to the issuer by the debt holder. As loans, debt is a liability of the issuer. Bond holders may have claims to specific assets upon default, but they are not owners of the issuing entity.
As preferred shares are equity in the company, there is no natural maturity date as with most debt. Although, as we will see later, a maturity feature may be added to the shares.
Preferred Status
As the name suggests, preferred shares have a priority to the company’s assets and earnings over common shares. However, usually debt issues have priority than preferred shares.
A higher claim on assets is important if the company breaks up, intentionally or not. If this occurs, preferred shareholders will be paid the par value of their shares before common shareholders.
The prioritized claim to earnings is crucial for dividend receipts. Dividends payments require adequate cash flow and earnings to ensure an uninterrupted stream to shareholders.
Dividends Not Capital Appreciation
Dividends are the main reason investors purchase straight preferred shares. Like bond coupons, preferred shares normally have a fixed dividend that is paid out quarterly (bonds usually pay semi-annually).
While many investors in common shares do enjoy dividends, the main motivation is the potential for capital gains. Again, this aligns preferred shares more in the debt than equity investment realm.
That said, there may indeed be capital gains (or losses) on preferred shares if sold.
As with bonds, the market value of preferred shares move in opposite directions to changes in interest rates. As general rates increase, preferreds with fixed rate dividends will fall in price. If rates decrease, the price of the shares will rise to reflect the lower yield in the marketplace.
Depending on the specific preferred share issue, there may or may not be participation in the company’s performance. If not, the shares will react in price as if they were bonds. If there is participation, the share price will reflect that.
Dividends Not Interest Income
Bonds pay investors interest on debt. Preferred and common shares pay dividends from accumulated retained earnings.
In many jurisdictions, including Canada, eligible dividends may be taxed at a preferential rate versus interest income. If so, then on an after-tax basis you will net more cash from a dividend than interest income at the same gross amount.
If you earn 8% interest and 8% in eligible dividend income, you will be better off owning the preferred (or common) shares than the bonds. The exact advantage will be based on the preferential tax treatment and your own tax status.
Tax treatment on interest, dividends, and capital gains varies significantly between tax jurisdictions. Taxation is a major investment consideration. Investors should gain, at least, a basic understanding of the differences.
Not All Dividends Are Taxed the Same
As well, not all income in a specific class may be treated the same for tax purposes.
In Canada, for example and writing in generalities, an eligible Canadian public corporation’s dividends may allow for a gross up and tax credit. Canadian private corporation dividends may or may not be eligible depending on the company’s tax situation. Foreign corporations generally are not eligible for the tax credit. You need to understand the different types of dividend income received, as that will impact your after-tax returns.
If you own shares or funds listed on foreign exchanges, withholding taxes may be deducted before paying out your dividends. Often you can “recover” via tax treaties, but be aware of this on foreign sourced income.
Dividends Must Be Declared
Interest on bonds is based on the loan terms. Interest is paid out of cash flow. If the company is unable to make an interest payment, that money accumulates and is paid as soon as possible.
Dividends are paid out of retained earnings and must be declared by the company. Preferred share dividends are paid out prior to any dividend payments to common shareholders. Understand the conditions for when dividends may or may not be declared. If you invest to earn dividends, you will want to receive them.
For “cumulative preferred shares”, any unpaid dividends accrue over time and must be paid in full before any other dividends are paid. Again, this is much like bond issues. If investors do not get paid, the interest or dividends owing cumulate and are back-paid. It is much better to invest in preferred shares that are cumulative in nature.
No Voting Rights
Like bonds, preferred shares typically carry no voting rights within the company. Voting normally resides solely with common shareholders.
However, if dividend payments have been missed by the company for a period, often the preferred shareholders are granted voting rights on a contingent basis (usually while the dividends are in arrears). Bondholders, too, may have some say in company operations while interest payments are in arrears.
While the above is generally true, like bonds, there are many permutations of preferred shares.
Also, companies may issue various classes of preferred shares with different features. These classes may rank equal in their rights or some classes may be subordinate in their claim to assets and earnings.
As was the case in our bond review, knowing the details for each issue is important.
Next up, we will review common preferred share features. Many are identical to bond features.