Introduction

Luck favors the prepared mind.

—Louis Pasteur

If you don’t profit from your mistakes, someone else will.

—Yale Hirsch

Despite its obvious importance to every individual, our education system almost totally ignores the field of finance and investments. Therefore, unless you earn an MBA in finance you probably never were taught how financial economists believe the markets work and how you can best make them work for you. The result is that most Americans, having taken a course in English literature in high school, have more knowledge about William Shakespeare than they do about investing. Without a basic understanding of financial markets and how they work there is simply no way for individuals to know how to make prudent investment decisions.

Most investors think they know how markets work. Unfortunately, the reality is quite different. As humorist Josh Billings noted: “It ain’t what a man don’t know as makes him a fool, but what he does know as ain’t so.” The result is that individuals are making investments without the basic knowledge required to understand the implications of their decisions. It is as if they took a trip to a place they have never been with neither a road map nor directions.

It is also unfortunate that many investors (and advisors) erroneously base their ideas and assumptions about fixed-income investing on their “knowledge” of equities. As you will learn, the two are completely different asset classes with different characteristics; even if the investor’s thought process is correct on the equity side it may not be correct in the case of fixed income. The result is that the investor often makes suboptimal decisions.

While education can be expensive, ignorance is generally far more costly, especially in the investment world—a world filled with hungry wolves waiting to devour the innocent sheep. Fred Schwed relates the following tale in his book ‘‘Where Are the Customers’Yachts? or a Good Hard Look at Wall Street.” An outof-town visitor was being shown the wonders of the New York financial district. When his party arrived at the Battery, one of the guides indicated some handsome ships riding at anchor. He said, “Look, those are the bankers’ and brokers’ yachts.” The naive customer asked, “Where are the customers’ yachts?” The yachts of the investment bankers and brokers are paid for by the ignorance of investors.

Benjamin Franklin said, “An investment in knowledge pays the best interest.” Your investment in knowledge is the price of this book and the time you invest in reading it. The interest you receive will be the knowledge you need to be an informed fixed-income investor. Informed investors generally make far better investment decisions. And being an informed investor will help prevent you from being exploited by investment firms that take advantage of the lack of knowledge the general public has about fixed-income investing. The result is that it is more likely that you will be the one with the yacht, and not your broker.

When most investors begin their investment journey they focus on equity investing. Fixed-income investing is often an afterthought. This is unfortunate because for most individuals fixed-income investing plays an essential role in their overall investment strategy. Think of it this way, if your portfolio was a stew, fixed-income securities would be a main ingredient, like potatoes or carrots, not just a seasoning (e.g., salt, pepper) you add but might be able to leave out without adversely affecting the quality of the stew.

While there have been many books written on fixed-income investing, there have not been any that we are aware of that have met all of the following objectives:

• Educate you on the characteristics of all the types of fixed-income instruments available to investors, fully describing their risk and reward characteristics in plain and simple English.
• Address taxation and asset location issues (whether the asset is held in a taxable, tax deferred, or nontaxable account).
• Provide a practical road map to the winning strategy.
• Help you choose the most appropriate investment vehicles.
• Help you learn the best way to implement the winning strategy.
• Help you develop your own investment plan in the form of an investment policy statement (IPS).

The goals of this book are to meet all of these objectives and to convince you that while the world of fixed-income investing is a very complex one, the winning strategy is actually quite simple.

We begin with understanding that one of three motivations generally drive both individual and institutional investors to purchase fixed-income investments. The first is to provide liquidity to meet anticipated and unanticipated expenses. Any investments made for this reason should be highly liquid and should not be subject to any risk of loss of principal. Thus it belongs in such instruments as fully insured bank accounts, U.S. Treasury bills, and money-market mutual funds that invest in short-term instruments of the highest investment grade. This portion of your portfolio should really not even be considered an investment (which implies the taking of risk), but rather it is savings.

A second motivation to purchase fixed-income instruments is reduction of portfolio risk. Fixed-income assets allow investors to take equity risk while sleeping well and not panicking when the bear inevitably emerges from its hibernation. For investors in the accumulation stage of their investment life cycle (planning for retirement) this is generally the role that fixed income plays in a portfolio.

The third motivation for owning fixed-income assets is to create a steady stream of income or cash flow to meet ongoing expenses. This is usually the main role for fixed-income assets for those in the withdrawal stage of their investment life cycle. While the three reasons for owning fixed-income assets are not mutually exclusive, once individuals enter the withdrawal stage of their investment life cycle (usually upon retirement) this often becomes the primary motivation.

You will learn that whatever the motivation for investing in fixed-income assets, there are some simple guidelines to follow in order to give yourself the best chance of achieving your objectives. The rules of prudent fixed-income investing are:

• Purchase assets from the highest investment grades, avoiding instruments with a rating below AA.
• Purchase assets with a maturity that is short- to intermediate-term, avoiding long-term bonds.
• Avoid trying to outperform the market either by trying to guess the direction of interest rates (extending maturities when you believe rates will fall, and shortening them when you believe they will rise) or by trying to identify securities that are somehow mispriced by the market. There is simply no evidence that investors, either individuals or institutional, are likely to succeed in this effort. The winning strategy is to be a buy-and-hold investor.
• Avoid the purchase of what are called hybrid securities. These are instruments that have characteristics of both equities and fixed-income assets. Among the hybrid instruments we will discuss are convertible bonds, preferred stock, and high-yield bonds.
• Invest in only very low cost vehicles, avoiding whenever possible high cost funds, whether the high cost is in the form of high operating expenses or commissions (or loads). You will also learn that it is generally a very bad idea to buy individual bonds from a brokerage firm, a bank, or an investment bank (the markups, which are hidden, would shock you—and they are as legal as they are amoral).

We will begin our journey through the world of fixed-income investing by covering what might be called “bondspeak.” In chapter 1 you will learn the “lingo” of the bond world. Unfortunately, without such knowledge you cannot make informed decisions. The second chapter is a detailed exploration of the risks of fixed-income investing. We then move on to discussing how bonds are bought and sold. Chapter 4 discusses how markets in general work. The knowledge gained will help lead you to the winning strategy. Chapters 5 through 9 cover the various taxable investments available to investors. We will discuss the pros and cons of each, and decide which instruments you should consider for purchase. Chapter 10 covers the world of municipal bond investing. Chapter 11 focuses on the development of a specific investment plan, an investment policy statement (IPS). It is designed to help you create your own unique plan. As you read through the book, use the glossary at the back for any technical terms you don’t recognize.

Reading this book will not help to make you rich. It will, however, make you a better educated and, therefore, wiser investor. And, it may save you from turning a large fortune into a small one. We hope you enjoy the journey.