Let Fixed-Income Securities Lend a Hand

Physician's Money Digest, November15 2003, Volume 10, Issue 21

Today's physician-investors facedifficult investment decisions.Investing all your assets in astock portfolio and tying yourhopes and dreams into 1 equity or ahandful of individual equities is a riskygamble. Diversification is the only realsolution to this problem. A truly diversifiedportfolio should include a combinationof stocks, cash, and fixed-incomeinvestments, including fixed-incomesecurities.

A fixed-income security, or bond, issimilar to an IOU. When you purchase abond, you're lending money to a government,federal agency, municipality, corporation,or other entity, which is knownas the issuer. In return for the loan, theissuer promises to pay you a specifiedrate of interest during the life (ie, thematurity) of the bond and repay the facevalue (ie, the principal) of the bond whenit matures. Unlike stocks, where you ownpart of the issuing firm, fixed-incomeholders are creditors of the issuer.

Prudent Investing

Fixed-income securities are verymarketable and are often bought andsold over time. There are 3 main reasonsto include fixed-income securitiesin your portfolio. The first reason isbecause they are historically less riskythan stocks. Highly rated fixed-incomesecurities are considered 1 of the safestinvestments you can make today.

Performance results:

According to Ibbotson Associates,between 1925 and 2002, stocks had anaverage return of 10.2%. Over the sameperiod, municipal bonds averaged a4.3% return, government bonds averageda 5.5% return, and corporatebonds averaged a 5.9% return. Althoughstocks provide the best opportunityfor long-term investment return,with greater return comes increased risk. A year-by-yearcomparison shows that fixed-incomesecurities can outperform stocks.

The second reason to purchasefixed-income investments: diversificationbenefits. Investing in several differentasset classes allows a physician'sportfolio to spread out the risk inherentin investing. Since an inverse relationshipseems to exist between fixed-incomesecurities and stocks (fixed-incomesecurities perform well in differenttimes during the economic cyclecompared to stocks), fixed-income allocationis a great financial buffer. Let'slook at an example to see how theseinvestments act as buffers.

Bottom line:

Between 1920 and 2002, the S&P500 had 3 consecutive years of negativereturns. If you only invested in stocksduring that time, you probably lostmoney. If you included fixed-incomesecurities in your portfolio, however,you probably experienced less loss.According to Morningstar (www.morningstar.com), during the same 3-yearperiod, the Lehman Brothers AggregateBond Index, which is regarded as a performanceindicator for the overall USbond market, had an average return ofapproximately 10%. Ifyou had included fixed-income securitiesas a portion of your portfolio, youwould have offset some of the lossesfrom the stock allocation.

The third reason to include fixed-incomeinvestments in your portfolio isto generate income. Fixed-income securitieshave a predictable stream ofincome payments and principal repayments.Investment in this asset class isdesigned to preserve and increase capitalwhile you receive a dependable incomestream. As physicians approachretirement age, they shouldn't be heavilyinvested in stocks. Instead, theyshould be most interested in protectingtheir nest egg. Of course, there are noguarantees in the investment world, butfixed-income securities are a pretty safemethod of investing.

Recommended Bonds

Success of any portfolio dependslargely on the asset mix between stocks,cash, and fixed-income investments. Ifyou're a physician-investor whose portfolioonly contains 2 of 3 assets (ie, stocksand cash but no fixed-income securities),consider purchasing the following 3bonds to complete your portfolio:

• US Government Bonds. This includesUS Treasuries and federal agencies(eg, Federal Home Loan Banks, theFederal National Mortgage Association,and the Student Loan MarketAssociation). These types of investmentsare less risky because they arebacked by the full faith and confidenceof the US government.

• Municipal Bonds. These bonds are alittle riskier than government bondsbecause they're usually used to financeprojects in cities around the country.Credit ratings on municipal bonds vary,depending on the financial stability of theparticular city or area where the bond isissued. Although they involve more risk,they also give the buyer the ability to takeadvantage of income tax deductions.

• Corporate Bonds. These bonds areassociated with a wide risk range becausetheir rating is based on the company'sunderlying financial stability. Corporatebonds often provide a much higherreturn, but with greater risk. Companiesuse corporate bonds as a method offinancing new capital. Physicians whoinvest in this area should be aware of acompany's financial stability.

Since investing in fixed-income securitiescan be a complex process, seek theadvice of a financial professional beforeyou include them in your investmentportfolio. A qualified advisor cananswer any questions you have regardingthese investments.

William B. Howard, Jr, is presidentof William Howard & CoFinancial Advisors, Inc, a fee-onlyinvestment and financial planningfirm in Memphis, Tenn. He has 23years of experience working withphysicians and was named 1 of the top 150 advisors.He welcomes questions or comments at 901-761-5068 or whoward@whcfa.com.