There is one constant that remains as true today as it was more than 20 years ago when I began my career in the financial services industry: Diversification of your portfolio is crucial to your investing success.

Owning fixed income investments as well as equity securities is a key to building that diversification.

There are significant differences between investing in equities and investing in fixed income. First, equity investing provides ownership. When you buy a stock, you become a shareholder in that company. And when you purchase a fixed income security, you are a lender.

The federal government, its agencies, municipalities, and corporations all issue fixed income instruments, and in various forms – bills, notes and/or bonds, in exchange for cash for various needs, including keeping the economy going, building roads, or acquiring other businesses or product lines. After all, who would possibly want to be an equity owner of the government’s operations?  The issuers of fixed income are, in essence, borrowing money from you, the fixed income holder.

Secondly, the ownership status of equities enables shareholders to vote, or have a say-so in the goings-on of a corporation, including changes in boards of directors, mergers and acquisitions, shareholders’ rights, etc. Fixed income holders generally do not have this right.

Thirdly, in case of liquidation or bankruptcy, fixed income investors have a priority claim on the assets of a corporation – well ahead of common shareholders, who – in such circumstances – are on the bottom of the totem pole when it comes to being paid back.

Lastly, fixed income instruments generally pay interest (in the form of coupons), which corporations deduct from their income. Therefore, that portion is not taxed at the corporate level. Instrument holders are then taxed at their personal tax rates. Conversely, corporations pay any dividends on equities and certain hybrid equity/fixed income instruments after net income is calculated, resulting in double taxation. That means the dividends are taxed twice – at the corporate level, then again when you declare them on your personal tax return.

In a nutshell, that is an overview of the mechanical differences between equities and fixed income investments, but it doesn’t begin to tell you why all investors should have a portion of their portfolios dedicated to fixed income, as well as equity instruments.

Part of that discussion is linked to each sector’s relationship to the economy and market movements.

Stocks outperform bonds over the long haul

You’ve heard it many times, and it is absolutely true. Over the long-term, equities consistently outperform bonds. But that’s not the whole story.

The returns on bonds do occasionally outpace that of stocks – for brief periods of times, such as these 3-year periods calculated by AIM:

• 1929-1932: Stocks lost 64.22% and bonds averaged a 19.75% return
• 1939-1941: Stocks were down 20.57%, while bonds grew 13.44%
• 2000-2002: Stocks declined by 37.61%, while bonds rose 48.44%

But, when stocks hit, they really gain, as you can see by the returns in these three-year periods:

• 1933-1935: Stocks were up 124.11% while bonds grew just 15.42%
• 1942-1944: Stocks grew 81.43%, while bonds managed an 8.34% return
• 2003-2006: Stocks rose by 49.66%, while bonds grew 18.66%

In just the last 35 years or so, from 1970-2005, the return for stocks and bonds averaged 11.1% and 8.6%, annually.

Going forward, for the next 20 years or so, market gurus expect large-cap stocks to average returns of 8.6% while bonds will likely grow by 4.4%, annually.

Consequently, you can see that during some periods, bonds out perform stocks, particularly in times of steady or decreasing interest rates. Fixed income holders are afraid of rapidly-expanding economies and growing rates, since as inflation creeps upward, it erodes the purchasing power of a dollar and bond prices decrease. Conversely, equities tend to fare better when an economy is booming. Therefore, including both in your portfolio can help offset declines in one market, when the other one is booming, mitigating your risk across differing economic cycles.

Fixed income investing has its own unique set of risks

Next, let’s discuss the risks of investing in fixed income instruments. As you know, the risks of investing in equities are a function of price fluctuations. Prices going up and down can grow or erode the value of your portfolio. Fixed income investing incorporates a few more risks.

Interest rate risk is a factor in fixed income investing, as bonds and interest rates have an inverse relationship. When rates increase, bond prices decrease, and vice-versa. Why? New bonds are issued at higher yields as rates increase, making the old existing bonds less attractive. And one important note: The longer a bond has to maturity, the more interest rate risk. That just makes sense, as over a long period of time, we will see many economic cycles, creating many intervals when rates will fluctuate.

Credit risk is the potential that the company, municipality or agency selling the bonds may default or go bankrupt, making them unable to make their debt payments. The exception is U.S. government bonds, which are backed by the full faith and credit of the Federal Treasury, so do not incur credit risk. For non-U.S. government bonds, it is important that investors check the bond ratings prior to investing. More on that in a few moments.

Industry risk includes factors endemic to industry that may drag down the performance of all or the majority of companies in industry. For example, when the technology bust hit around the turn of the century, pretty much every computer-related company saw its stock price dive – no matter if it was the best-run, most profitable business in its sector.

Inflation risk is simply theerosion of the value of the income stream, or cash flow that you expect from the fixed income investment, during inflationary times. In other words, as prices rise, your dollar buys less.

Call risk occurs in times of declining interest rates. If a bond issuer can issue new bonds and pay less of an interest rate then its existing bonds, it will do so. For the bond holder, that means your high rate bond may be called, and you then incur reinvestment risk, as you may have difficulty – in a lower rate environment – finding an investment that pays a rate similar to your existing bond.

Prepayment risk: When rates fall, mortgage holders refinance, or prepay their loans. Investors holding mortgage-backed securities will then find themselves being paid out early, losing their high rates of interest, and also incurring reinvestment risk.

There’s not a whole lot investors can do about most of these risks, except to be aware of them. But credit risk is a risk that you can significantly lessen, just by knowing the bond rating of your potential investment. Realize that the higher the rating, the safer the investment, and generally, the lower the return you can expect. Likewise, for highly speculative investments, the bond rating will be lower and you can expect a higher return to compensate you for the risk you are taking.

Bond ratings can reduce your credit risk

Here are bond ratings from the three companies whose ratings are commonly relied upon by legions of fixed income investors: 

Source: www.bondsonline.com