Thursday, September 18, 2008

I don’t understand what is going on, should I be concerned?

As I look at the last three days, I have to tell you that in 35 years in this business I have not seen the level of chaos that I have seen this week. I realize that the markets are in turmoil and though it is not the end of the world, the fear level is high.

I looked this morning at the yield on the 90-day T-Bill and it was just under one/third of one percent, about 30 basis points. Later in the day, you had to go out 11 months to get a positive yield in a T-Bill. If you wanted to buy a 90-Day T-Bill you had to pay the government for the right to buy, you lost money. This level interest rates tells me that the world is in panic. In the crash of 1987 all, the equity markets in the world were coupled in going down.

We know from history that all the markets can go down together for a short period, but they will begin to decouple and sort themselves out. It was a scary time in 1987 and it is a scary time today. Order will return to the markets it will just take some time for it to return.

My wife asked me a question about her account, she said, “If I wanted to take my money out of my account to buy a boat, based on the current value of the assets I couldn’t buy the boat.” I said either she would have to buy a smaller boat or wait a while to buy the boat she wanted. Her real question had nothing to do with a boat, but the income that was coming out of the account and how secure it was. I have had several clients call and ask me a similar question.

I explained to my wife and to my clients that the income you receive in a fixed income investment is not related to the price of an investment. Let me use some examples to illustrate the point. Let us say you by a ten year maturing US Government bond that has an interest payment of 5%. That means for every $1,000 in bonds you own the government will pay you $50 per year. Let us suppose that next year the interest rates for a new bond are 5.5%. Because the new bond pays a higher interest rate, the value of your 5% bond will be reduced to make it equal to the 5.5% bond. The price of the bond might go from $1,000 to $975, but the amount of interest you receive on your bond is still 5%.

Similarly, if next year the interest rates fall and the new bond rate is 4.5% your income will still be $50. The value of your bond may go up or down, but your income does not change. The rate of interest in effect at the time of the purchase is the rate you earn regardless of the level of interest rates in the future. This is true on government bonds, tax-free bonds, corporate bonds and CDs. Any investment that has a fixed rate of return at the time of purchase offers predictable income. Bonds and preferred stocks are fixed income investments that for the most part are the most secure investments in companies.

On the other hand, common stock has the most risk and potentially the most reward in the ownership in the company. For the vast majority of my clients they prefer knowing what rate of interest they are going to be paid. Therefore, to sum up, fixed income investments can go up or down in value, but the income will stay the same regardless of the market value of the investment.

If you have set up an income portfolio the checks will keep coming in every month that is the most important thing. Look at the value of the investments, but remember why you made the investment. Nobody likes to see the markets decline as they have over the last week myself included. The account statements for the month of September will be awful because the markets have been a disaster.

Keep in mind the reasons you invested your money and realize that things will turn around, but perhaps not as fast as we would like.

Dan Perkins

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