4 questions your clients need to ask about income investments

Wealth Solutions

4 questions your clients need to ask about income investments

Understand the various risks to income investing and their impact on your clients’ portfolio.

Understand the various risks to income investing and their impact on your clients’ portfolio.

The markets present investors with challenges – the reliability of income, as well as interest rate and credit risk– that should always be considered when evaluating income-producing investments. When it comes to reliability, investors should understand the difference between income from stocks and bonds. Interest payments on bonds are an obligation of the issuer and can generally only be interrupted if the issuer defaults. Dividends on stocks, on the other hand, are only paid when, as and if the board of directors declares a dividend. Rising interest rates can have a significant impact on the value of these investments, and there are a variety of investment strategies available to help manage those risks. It’s important to understand which types of risk your clients are comfortable with and the tradeoffs associated with each strategy.  Be sure to have them address these four key questions:

1. What do they own and why – what role do income-producing securities play in their portfolios?

Individual bonds have long been the traditional option for fixed income, and packaged products are a popular vehicle to access these investments since they offer money management and diversification. Once you identify the bond holdings in your clients’ portfolio, it’s important for them to understand why they own them. For example, they may include bonds in their portfolio for:

  • Predictable income*
  • Diversification from equities
  • Preservation of capital*
  • Total return opportunities

Depending on the specific role these investments play in their portfolio, the associated risk factors will have a different impact on their decision-making process.

*It is important to note that not all investments that hold bonds offer all of the above listed qualities. In fact, only individual bonds with stated maturities and for which you control the ‘buy, hold or sell’ decisions offer predictable income and preservation of capital in the form of known maturity values and dates.

2. What will happen to their portfolios when interest rates rise?

While traditionally serving as a low-risk position in your clients’ portfolio, bonds do pose risk in a rising interest rate environment particularly for individuals seeking total return opportunities. For example, when interest rates rise, bond prices decline. Additionally, holdings with higher duration, a measure of price sensitivity to changes in interest rates, will experience larger price swings in response to rate movements. Still, duration should not be avoided altogether. Understanding the benefits and risks associated with duration during various interest rate environments is prudent in understanding the trade-off of potentially higher income versus undesired changes in value.

Note: These are examples and approximations. This example assumes non-callable bonds. Callable bonds have different sensitivities when they are priced above 100.00. The change in value shown is specific to a 1% rate change in similar securities. If the rate change was only 0.50%, the value change would be roughly half of what is shown. By extension, if the rate change was 3%, the change in value would be approximately 3 times what is shown.

If your clients own individual bonds to receive steady, consistent income, they may not be as concerned about changes in the value of their bonds since they will continue paying periodic interest and return face value on a specified date barring issuer default. However, if your clients are using bonds to achieve an attractive total return, you may want to structure their portfolio to better achieve this goal during a rising rate environment.

3. What other risks are they exposed to?

It is important to understand that there are tradeoffs with every decision you make in your clients’ portfolio, as you may find yourself trading one risk for another. For example:

  • Shorter maturity bonds of similar qualities will typically have lower price volatility but a lower yield
  • Higher yielding bonds produce more income than investment-grade bonds but typically carry higher credit risk. Higher-yielding bonds of similar maturities generally present higher credit risk
  • Non-U.S. dollar investments, such as foreign bonds, can provide diversification and attractive returns but carry currency, credit and geopolitical risks

How certain risks will impact a portfolio differs depending on your clients’ objectives and the types of investments they own.

4. What action should be taken to mitigate risks and still achieve their goals?

Start by confirming why they own income-producing investments, the role they play as a part of your clients' overall asset allocation and evaluate their risk tolerance in view of the risks that may be present going forward.

You can run an analysis on any individual bonds your clients own to assess their credit quality, exposure by credit rating and diversification across issuers. You may be able to use this analysis to quantify the potential impact of rising interest rates on the value and total return of your clients' individual bond holdings.

Do not confuse individual bonds with packaged products. Individual bonds provide finite maturity dates while bonds in packaged products only offer shared interest in a pool of bonds with outside managed control which may be impacted by fund flows, changes in the fund management team or other factors.   Individual bonds allow an investor to control ownership or action. 

You can determine whether your clients' investment objectives or if changes are deemed appropriate While we do not recommend dramatic changes to asset allocations based upon day-to-day market movements, there are a number of strategies available that may help manage long-term risks such as:

  • Knowing what your clients own and managing the duration of their investments appropriately
  • Improving the credit quality of your clients' investments
  • Diversifying across different types of income-producing investments and issuers
  • Structuring the bond portfolio to allow for a disciplined investment strategy. 

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