Advisory Column: Assembling an income portfolio
QUESTION: I have been reading up on investing, seeing that it is something I would like to try. Could you explain to me what an income portfolio is?
FINANCIAL ADVISOR: A portfolio is a group of financial assets. It includes cash, near cash, such as savings accounts and certificates of deposit, interest-bearing securities such as bonds and debentures, unit trusts and mutual funds and stocks.
What you call an income portfolio would comprise financial assets that yield interest income.
A significant portion of that portfolio would be debt securities such as bonds and debentures. Securities are financial assets that are tradeable and transferable.
Investors lend money to the issuers of interest-bearing securities, who, as borrowers, commit to pay interest at a set rate on pre-determined dates and to repay the principal borrowed on a pre-determined date.
Issuers may be corporations or governments. Lenders may be individuals, corporations, pension funds, and governments. Some of these securities trade on stock exchanges, but others trade over the counter.
A primary advantage of these interest-bearing securities to the investor or lender is preservation or safety of capital. To the extent that issuers do not default, investors will receive the sums they invest at maturity. To the extent that they hold the instruments to maturity, investors will recover their full investment.
Should they choose to sell the securities before they mature, they risk losing some of their principal if interest rates increase but may gain if interest rates fall in relation to what they were at the time the bonds or debentures were bought.
A portfolio made up of interest-bearing securities does not offer much protection against inflation due to their limited ability to increase in value.
There are several ways to protect the value of such a portfolio. Each is a form of diversification. If a portfolio is made up of securities that have different maturities, its value is protected to the extent that the change in their values is not to the same degree in response to interest rate changes.
Short term instruments fluctuate in price to a lesser degree than long term instruments. High coupon instruments - those paying a higher stated rate of interest - experience less fluctuation than low coupon instruments.
Diversifying by currency also protects the value of a portfolio as, in the case of devaluation, for example, foreign exchange gains can be realised on interest payments and the principal sum invested when the instruments mature.
Portfolios can also be diversified by the quality of the instruments. Higher quality instruments generally pay a lower rate of interest but the lower quality ones pay a higher rate to compensate investors for the higher risk they take.
Government debt instruments are generally considered to be safer than corporate debt instruments and this is generally reflected in the interest rate. But the debt of some countries may yield more than the debt of others because of the higher risk associated with the former.
In the case of debt issued by corporate bodies, or companies, the degree of risk varies and this is reflected in the rate of interest paid. In some instances, it is possible to get an idea of the quality of debt by referring to the grade given them by rating agencies.
Although not so common, there are bonds and debentures that pay a variable rate of interest. The interest paid at each payment date is based on the rate paid on a specified instrument such as a particular instrument issued by a government or central bank.
A portfolio of income-bearing securities is of particular value to investors who require a known and reliable stream of income. It is also appealing to investors who tend to be more conservative, that is, more risk averse.
Older investors, particularly retirees, tend to see value in building income portfolios as they are less able to bear risk and tend to require a regular flow of income. Persons saving towards short term goals may also find such portfolios attractive.
But because of the limited ability of interest-bearing financial assets to keep up with inflation, it is advisable for some persons - especially those investing for the medium to long term - to have some of their funds in instruments such as ordinary stock or capital growth unit trusts and mutual funds, which have the ability to appreciate in value and thus offer some purchasing power protection.
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. firstname.lastname@example.org