Fixed Income Values
By Doug Lyon, CFA

With the current marketplace teeming with undervalued equity securities we have also discovered outstanding values in the fixed income area, especially in REITs (real estate investment trusts), preferred stocks and corporate bonds. We are finding yields for these relatively lower risk securities as high as 9 to 15%. How can this be? Investors are overlooking bonds and preferreds offered by established companies with very long track records of delivering on earnings and growth in favor of the high flying techs. This presents opportunities for the astute investor. We have been building strong fixed income portfolios for those who are risk averse or more interested in current income. We have also been adding these securities to some of our more aggressive equity portfolios because they are just too good to pass up. If you have an interest in taking advantage of these same opportunities, give us a call. $$

Revisiting Dividends
By Doug Lyon, CFA

Last winter we wrote about dividends. For serious investors who read this newsletter more attention to the topic is needed. Based on experience there seems to be little correlation between stock buy backs and stock price appreciation. There is however a very direct correlation between dividend payments made and cash appearing in shareholders' pockets.

Throughout history dividends have been a significant, though an often overlooked component of return generated by investments in common stock. For the last 50 years the S&P 500 index has had an average annual increase of 9.25%. Including dividends the return is 13.45%, a difference of 4.20% yearly. Now that does not sound like much but over time the difference looms quite large. An annual increase of 9.25% compounds to a cumulative return over 50 years of 8,305%. 13.45% compounded over 50 years produces a return almost seven times as large. The comparison holds over all periods of market history.

The conclusion is that dividends do matter. So in this age of pundits and investment gurus touting companies with no earnings and no dividends, we still look for companies that pay dividends and have a long track record of doing so. We believe our clients will be well rewarded over the long term for owning such stocks. $$

Electronic Newsletter Extra Feature Article:

Fixed Income Investing
By Doug Lyon, CFA

Most of what you hear about these days regarding investing is STOCKS, STOCKS, and STOCKS.  Granted you may hear a snippet about the bond market from time to time but not as much media attention is devoted to bonds, cash and other types of fixed income investments.   While they may seem boring they are an extraordinarily important component of any portfolio

Basic Definitions

Fixed income securities are an obligation of some entity, often a corporation, government or municipality, to pay the holder of these securities a fixed payment.  The amount and timing of the payment is almost always designated when the security is first issued.  A fixed income security is a loan, the investor is the lender and the issuer is the borrower.  The payment to the investor is interest for the use of the money.

When the security is first issued a maturity date (the date when the full amount of the principle is repaid) is established.   When an investor purchases a fixed income security he always has the option to hold the security until it matures and collect the full principle at that time.

Most Lyon Capital Management clients have portfolios that contain some fixed income securities.  Fixed income securities are used when an investor wants a predictable stream of income for a certain period of time.  These securities are also used as diversifiers to stocks.  They tend to generate lower returns than stocks but they are also are less volatile.

We use five basic types of fixed income securities:  United States Treasury securities, tax-exempt bonds, corporate bonds, preferred stocks, and cash.

Treasury Securities

United States Treasury Securities are obligations of the US government.  These securities are considered to be the safest securities in the world.  Their interest payments and principal payment are guaranteed by the US government.  We use these as a risk-free base on which to build most portfolios.  The bonds pay interest semi-annually.  The market for US Treasuries is very liquid (they can be bought or sold at any time with very low transaction costs).

Transaction costs include commissions as well as a “dealer's markup”.  Securities are bought and sold just like all other goods of trade.  A dealer buys for one price marks up and sells for higher price.   When an investor wants to buy a security she usually goes to a broker, gives an order, and the broker goes to a dealer and, acting as the investor's agent, makes an offer to buy.  If the transaction is completed the investor will pay the broker a commission for his work but the investor will also pay the dealer's markup.  In this day and age of ever lower commissions the dealer's markup is often much larger than the commission. This markup is a hidden cost that is difficult to measure. Sometimes the lower the commission, the higher the markup. 

Tax Exempt or Municipal Bonds

Investors in tax-exempt bonds are exempt from paying taxes on interest income received from holding the bonds.  These bonds are generally issued by state or local governments or municipalities.   The proceeds are used to fund certain projects or operations.  For example the New York State Thruway issues bonds. The proceeds are used to repair Thruway bridges.  Almost all tax-exempt bonds are exempt from federal income taxes.  Most bonds are also exempt from state and local income taxes if they are held by investors who are residents of the state of issue.  For example, if a New York State resident invested in bonds issued by North Carolina she would pay no federal taxes on interest income received but would pay New York State taxes on the income.  In order to pay no state or local taxes on the interest income, she would need to invest in bonds issued by a New York State based entity or move to North Carolina.

The value of a bond  is determined each day by investors, brokers and dealers participating in the marketplace.  A bond's value is determined by, among other things, the level of interest rates, the level of inflation, the credit worthiness of the issuer, and the time until the bond matures.  The bond's value as determined by the marketplace can change daily but the amount and timing of the interest payments do not.  Interest payments made by the issuer of a bond are interrupted only in the event of bankruptcy. 

The value of a bond moves in the opposite direction from interest rates.  The reason for this is the fixed payment of income.  As rates go up, the fixed payment is worth less.  As rates go down, the fixed payment is worth more.  The longer a bond has until maturity or full repayment of the loan principle, the more sensitive the value of the bond is to changes in interest rates.  As an investor, if you believe interest rates are likely to increase you want to lend for a short period (so you can take advantage of the higher rates later on) and if you believe rates are headed lower you want lend for a longer period (to lock in the higher rate.)

Preferred Stocks

Preferred stocks are also fixed income securities.  At the time they are issued a dividend rate is set and it does not vary.  When investing in a preferred stock the issuer's creditworthiness is the important variable.  

The investor must weigh the potential future return from the investment against the likelihood of the issuing company's ongoing ability to continue to make preferred dividend payments.

The company issuing the preferred always has the option of suspending the preferred dividend but often the dividend paid on the company's common stock must be terminated before the preferred dividend is suspended.   Most dividend paying companies terminate their common dividend and suspend the preferred dividend only under the most serious of financial difficulty.  Preferred stocks are called preferred because they receive preferred treatment over the common share holders in two ways:  the preferred stock dividends are always paid before any payment is made to common shareholders and in a liquidation, the preferred shareholders gets paid before the common shareholders get anything.

Many preferred stocks are classified as "cumulative preferreds" this means that if the preferred dividend is suspended any dividend payment not made is accumulated and if the company starts paying the dividend again, the company must pay all dividends accumulated since the payment was initially suspended.  Common stocks do not have this feature.  If a common stock dividend is suspended then the common share holder can not ever recoup the lost payments.

Cash

Cash is the lowest risk fixed income investment.  Typically cash can be held, with an institution paying a minimal amount of interest as shares in a money market account or as a Certificate of Deposit(CD).  A CD will usually pay a level of interest higher than a money market account because you must hold the money in the CD for a set period of time or incure a penalty.

If you would like to discuss structuring a fixed income portfolio with Lyon Capital Management, give us a call at 585-248-9821. $$

24B Grove Street, Pittsford, NY  14534
Tel: (585) 248-9821