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Fixed income securities for retirement

Published:Sunday | September 21, 2014 | 9:00 AM

Oran Hall, Contributor

Fixed income securities are debt instruments. Their issuers promise to pay interest at specified times and rates and to repay the principal on the maturity date. They are useful because of the predictable stream of interest income and the repayment of principal that retirees and other investors are promised.

But there are several risks associated with them, including interest rate risk, re-investment risk, exchange rate risk, inflation risk, liquidity risk and credit risk.

Interest rate risk refers to the possibility that changes in the interest rate may negatively affect the value of the investment. If, for example, an instrument is sold before maturity and interest rates have risen above that of the fixed income instrument, the price of the instrument would fall thus causing a capital loss.

The possibility of retirees encountering emergencies that may make it necessary to sell such instruments prematurely exposes them to the risk of capital loss.

Different maturity dates

It is important to have instruments that mature at different times and to note that the lower the coupon, or stated interest rate, the greater the change in the price of the bond or debenture when interest rates change. Additionally, the further away the maturity date, the greater the capital loss.

On the positive side, a fall in interest rates would cause prices to rise thus returning a capital gain to the investor.

Re-investment risk is also associated with changes in the rate of interest. In this case, it applies to re-investing the periodic coupon payments and the principal repayment at maturity at a lower yield than the yield at which the instrument was purchased.

On a positive note, a rise in interest rates is favourable as coupon payments and the repaid principal can be re-invested at a higher yield.

Exchange rate risk applies when the investment is made in a currency other than the investor's home currency. Exchange rate movements affect both the interest payments and the principal when it is repaid.

In the event of revaluation, the investor gets less in the local currency. The corollary to that is depreciation in the value of the local currency yields more to the investor - a situation we are very used to.

Bear in mind that our currency may see a reversal in its fortunes some day.

Purchasing-power risk

Inflation risk is also called purchasing power risk. Inflation, or a rise in the general level of prices, reduces the real value of interest payments and the principal when it is repaid as the same nominal amount of money will purchase fewer goods and services.

This is one of the most serious challenges that retirees face in our local context. It is, therefore, necessary to have other investments that can keep in step with inflation although they tend to have a greater risk of capital, loss.

Liquidity risk is very real for retirees, who may need to sell investment instruments quickly with minimal risk to their value to meet unforeseen developments.

If instruments are not marketable, it is highly unlikely that they can be sold prior to maturity at or near to their true value. It is thus important to pay very close attention to the quality of the fixed interest securities that are included in the investment portfolio of the retiree.

Default risk is also known as credit risk and refers to the risk of the issuer defaulting on the interest and/or principal payments. This may also refer to the credit rating of the bond changing thus leading to a lowering of the price.

Although the financial condition of issuers do change, it is important to pay close attention to the financial strength and reputation of the issuer.

Of note in our local context is that there are few corporate debt issues, most interest-bearing securities being issued by the government. Investors with an appetite for foreign debt securities should act with the greatest level of prudence.

Although I mentioned earlier that it is prudent to spread out the maturities of instruments, it is important to observe that the rates on short-term instruments are generally lower than rates on long-term instruments. The instruments carrying the highest risk are long term, low coupon instruments as their prices swing quite sharply in response to interest rate changes.

Last week, I suggested that laddering was one strategy that could be used for managing fixed-income portfolios. This is a conservative, buy-and-hold strategy which helps to reduce interest-rate risk and, to some extent, liquidity risk. It involves building portfolios of bonds of equal dollar values at regular intervals, which allows for greater exposure to less liquid but higher-yielding bonds.

A key element of this strategy is that over
time, the proceeds of the shortest, term maturities are re-invested in
longer-term bonds, which have a higher yield if the yield curve is
normal, and will result in a reduction of re-investment risk and, over
an extended period, raise the yield of the
portfolio.

It is worth observing that there are limits
to the efficacy of this strategy due to the fact that no one can
forecast with pinpoint accuracy where interest rates will
go.

To build an effective fixed- income securities
portfolio for retirement, I suggest selecting instruments of a high
quality and with various maturities.

For guidance,
consult a qualified investment adviser or two.

Oran
A. Hall, a member of the Caribbean Financial Planning Association and
principal author of 'The Handbook of Personal Financial Planning',
offers personal financial planning advice and
counsel.finviser.jm@gmail.com