All Fixed Income Investments Come With Risks
Investors relying on fixed income investments for income have been hit with the double whammy of rising inflation and lower interest rates. In the search for higher income, they often overlook the many risks associated with fixed income investments.
The Wall Street Journal recently ran a story about a Philadelphia mortgage lender, American Business Financial Services Inc. The company raised capital for lending by touting a “24 month investment yielding 9.14 percent annually” in newspaper and direct mail ads,Landscaping at a time when the two-year Treasury notes were paying 3 percent.
For additional capital, ABFS also securitized their mortgage loans and sold them off to investment banks. When mortgagees began to refinance, the loans were paid off and ABFS found itself owing both its noteholders and the investment banks. By January 2005, ABFS was out of money and forced into bankruptcy. The noteholders ended up with nothing.
The lesson we can draw from this vignette: All fixed-income investments carry some sort of risk, and investors must be able to recognize the risks when lending their money.
The most common risk, and most easily understood,Landscaping is the risk of not being paid back. Is the lender reputable? How strong is its balance sheet? Does the lender have a viable business that will earn the money to pay back the loan on time? Is the lender’s business in an industry that is stable?
As is typical of most corporate loans, the ABSF notes were not secured by collateral. Investors had to rely strictly on the creditworthiness of the borrower. Creditworthiness of corporations, banks and governments can be checked through one or more of the seven reporting agencies that provide business and government credit reports.
Moody’s and Standard & Poor’s are the most commonly quoted reporting agencies. Both use a letter system to rate borrowers. Their respective highest ratings are Aaa or AAA. Ratings lower than Baa or BBB are considered speculative and not investment grade.
Some municipal bonds may be insured for repayment of principle and interest, offering a higher degree of safety for the investor. Bank deposits are also protected up to $100,000 per depositor by the Federal Deposit Insurance Corp. (FDIC).
Finally, in the event of bankruptcy, bond holders have preference over stock holders when it comes to the assets. However, if the borrower has secured other loans with those assets, the bond holder is second behind the other secured interests.
More subtle risks that are not considered by credit reporting agencies include interest rate risk, reinvestment risk and purchasing power risk. A maturing investment has to be reinvested in order to continue the income stream. If interest rates have fallen, the new CD or note will carry a lower interest rate and generate a lower income stream. If interest rates go up, the noteholder’s note is worth less and, if forced to sell, the holder may not get back the entire investment. Purchasing-power risk means simply that a dollar of income tomorrow may not buy as much as a dollar today.
In the ABSF case, we have investors who were lured by the 9.14 percent return and ignored the risks. They bought into a complex financial engineering scheme laid out in a 230-page prospectus by ABSF that supposedly spelled out the risks. Landscaping If this had been a truly low-risk investment, the world’s capital markets should have drowned the company in cash. The high spread between the two-year Treasury and the 9.14 percent offered was too good to be true. Even my brother-in-law looks good compared to those guys!
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