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The Investment Climate: Bonds and diversification

By John Ferebee/Contributor

When it comes to earning money through investment, there are really only three broad categories: those based on ownership of an asset such as stocks or real estate; those based on lending money to an institution such as corporate or government bonds; and interest payments from a bank.

Although we believe that share ownership of well-run businesses is the foundation of long-term wealth creation and retention, there also are many situations in which investors should add an income strategy to this main foundation.

While the common stereotype of bond investments is that they are “boring” and “safe,” the reality is that debt-based instruments are fundamentally composed of an IOU from a borrower, and because of that fact they behave in distress very differently from ownership-based investments such as stocks. The nature of an IOU is very black-and-white: You are receiving payments from the borrower, or (in the event of a failure of the borrower) you are not. In other words, when things go wrong in the world of an IOU, it often takes the form of a sudden transition from “you’re getting your payments and everything looks fine” to “you aren’t getting your payments, and getting your principal back is now questionable as well.”

Note that most of the financial crises of the past 30 years have centered on failures in one part of the bond world or another: the Latin America debt crisis of 1982, the “Asian contagion” of 1997, even the implosion of long-term capital management’s government-bond arbitrage scheme in 1998.

This is not to suggest that debt-based instruments are inherently problematic or that investors should avoid them, but rather to point out the sudden nature of default when it does occur. When those problems do occur, often leverage has been added to the equation. Today’s mortgage and credit crisis underscores this.

Because there is risk in debt-based investments, we believe that it is very important to diversify sources of income payments inside a proper income strategy. In addition to owning bonds from different issuers, we also believe that cash-flow sources other than bonds should be part of the strategy.

This also applies to investors who are getting interest payments from banks. Interest payments shouldn’t be coming from one big bank CD issued by a single bank.

Money market funds, while not insured by the FDIC, are by nature pools of literally hundreds of debt-based instruments, giving them much greater diversification of income, which we believe is an important aspect of income strategies.

Finally, the reality of inflation is critical. With debt-based investments, the contract says it will pay you back whatever is says it will pay back and nothing more. But as inflation causes the dollars it pays back to purchase less, it is effectively paying back a smaller amount over the years.

For all these reasons, it is clear that ownership-based investment should form the foundation of an investor’s long-term strategy, and why we say that income strategies can be built on top of that foundation, rather than ever being the foundation itself.

John Ferebee is director of wealth planning with Taylor Frigon Capital Management, an investment advisory firm. He has more than 37 years of experience at financial institutions. For more information, visit www.taylorfrigon.com.