Often an Alternative, Rarely a Substitute - Butler Financial, LTD
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Often an Alternative, Rarely a Substitute

December 21, 2020

Dough Drabik discusses fixed income market conditions and offers insight for bond investors.

Tis the season! No, I’m not going to try my hand at another poem even though I so enjoy the season’s challenge. The season I reference today is the “Substitute Season.”

Every time interest rates create income-producing challenges, all the “at-the-moment” substitutes try marking their claim as fixed income alternatives.

John Madden, the famous former football player, coach and sportscaster, made famous the Turducken. The best description I read described it as a “hot, meaty, mess.” A turkey stuffed with a duck stuffed with a chicken. Perhaps a fun dish with potentially fine culinary mouthwatering attributes as a Thanksgiving dinner alternative; however, certainly no turkey substitute.

This imaginative feast is not to be confused with the turDunkin.’ A turDunkin is a turkey brined in Dunkin’ Donuts coolattas, stuffed with munchkins and served with coffee gravy and mashed hash browns. Another inventive culinary Thanksgiving dinner alternative but lacking the purity and basic foundational merit as a turkey substitute.

As unique as turkey is as an American bird, so too are bonds unique in the characteristics and proficiency with which they can serve the investment portfolio. Succinctly designed, bond characteristics serve to protect principal in a way most alternatives do not.

Fixed income should not to be confused with total return investment plays designed for momentary income windfalls. Contrarily, bonds are long term commitments independent of market appreciation. The cash flow and income are “fixed” and are not altered by market volatility which might occur during their holding period.

It is important to distinguish “alternatives” with “substitutes”. Turduckens and turDunkins’ are alternatives but by no means substitutes to turkeys. Annuities or dividend paying stocks, both often mentioned as fixed income alternatives, are very different investments providing very different risk profiles and purposes. These are not bad investments, just very different investments with different risks as well as different uncertainties and therefore alternatives, not substitutes.

Fixed income portfolios do not need to rely on one product or one obligor. Diversification is part of the protective nature associated with designated fixed income allocations. Outside of an outright default, principal is protected and returned on a specified date. It is inherited by the estate in the case of a death, never surrendered. Upfront commissions are one time and modest or sometimes absent in lieu of modest portfolio fees. Coupons are consistent and fixed, never needing yearly approval once the debt contract is issued. There is not any early withdrawal penalty, only market pricing,  that affects an investor deciding to sell and reclaim their principal.

The highlight feature of fixed income is their stated maturity, the future date when face value is returned. Any market volatility which occurs during the holding period has no effect on the investor that holds their bonds through maturity.

Alternatives exist with most products, but they typically display very different risks regardless of promised rewards. Bonds’ primary purpose for many investors is to protect principal and secondarily, provide income. Although some alternatives can target competitive incomes, few exhibit the protective characteristics and known future rewards associated with bonds. Don’t confuse alternatives as substitutes for the portfolio’s fixed income allocation.

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

Stocks are appropriate for investors who have a more aggressive investment objective, since they fluctuate in value and involve risks including the possible loss of capital. Dividends will fluctuate and are not guaranteed. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

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