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Letting Dividends Do Their Work

Castor Oil or Learning about Bonds?

George C. Fisher

A tablespoon of castor oil or the boring market action of bonds? A little taste of “WD40 for the gastro-intestinal tract” or learning about how bonds move with interest rate swings? Which is worse?

My great-grandmother was a big castor oil fan. I can remember, as a child, her spinning tales of everyone in her family getting their healthy dose of a few sips of that horrendous tasting liquid. As painful as the daily ritual was, my great-grandmother believed the process of ingesting some dreadful castor oil was good for the body and for the spirit.

While some may think learning about fixed income securities is only a tad bit above gulp down castor oil, I believe bonds can be good for every investor’s financial body and spirit.

I like bonds and have for many, many years. However, early in my investing lifecycle, I thought bonds were dull, dry, and boring. Over time, I began to value the understated attributes of fixed income investments. A few of their attributes, in my opinion, could be relatively anticlimactic for those looking for eBay-type market action. Stability of income and capital preservation are terms most equity investors under appreciate. Add long, tedious price trends to the mix, and castor oil’s appeal begins to look pretty good.

I believe every portfolio in excess of $35,000 should have at least a 15 percent asset allocation to fixed income securities. This would equate to a $5,000 bond investment for every $30,000 of equity value. As we mature, the percentage of a portfolio dedicated to fixed income securities should increase as our financial goals move from capital generation to capital preservation. With this strategy, bonds can account for a significant dollar amount in an investor’s overall portfolio. As with any significant investment in a portfolio, it is important for investors to become educated on the workings of fixed income securities and the forces that affect their value.

Most investors like to see their newly added capital contributions increase in value. If I toil at my job, scrimp and save $5,000, and make an investment in a stock, I would like to see that hard earned money grow at an appreciable rate. However, once that hard earned money has doubled to $10,000, I have both my capital and a substantial profit. By selling half the stock position, I retain my initial capital investment in the equity position and free the profit for diversification.

Preservation of profits through investing in fixed income securities is a self-induced trick I used to justify and build my first bond positions. I still use this strategy today. As my equity portfolio grows, I siphon off some profits from equity trades to my bond portfolio. Over time, this strategy becomes much less painful than my great-grandmother’s daily dose of castor oil.

For eBay-type action junkies, fixed income securities investing can provide an interesting ride. Most of us still remember Y2K and the turn of the century. In 1999 and 2000, the feds were raising interest rates to cool an overheating economy. The curve was flattening, leading to an eventual inverted yield curve (see Bonds Part I). Newly issued 30-year Treasury bond yields were rising above 6.0 percent, and recently issued bonds with lower interest payment coupon rates were selling at a discount.

On Feb 15, 2000, the S&P 500 was at 1,399 and US Treasury Inflation Protected (TIPS) bonds maturing in 2028, with 3.625 percent interest coupon indexed to inflation, were trading at $95. The fixed payment yield on a similar bond was a comparable 6.50 percent.

The S&P is currently trading at 1,210, or 189 points below its Feb. 2000 value representing a net loss of 13.5 percent. The 2028 TIPS, however, have increased in price from $95 to $152, for a net gain of 66.8 percent. The inflation adjusted yield has dropped to around 2.2 percent, reflecting a comparable 4.70 percent yield on fixed payment bonds.

I know all this because I bought a $5,000, 2028 TIPS on Feb 15, 2000 for $4,800, through my stockbroker. The TIPS are currently quoted as having a value of $8,007 each. Plus, I received $206 in cash interest last year. Since 2000, I have earned a total of $982 in cash interest, adding 20.4% to my overall investment return. Where did I get the $4,800 from? The sale of 35 shares Motorola stock at around $150 (pre-3 for 1 split) a share.

I repeated a variation of this same strategy on March 15, 2000 when the S&P was at 1,462. I sold $4,800 of some other equally inflated equity and bought a $5,000 TIPS maturing in 2008, also with an interest rate coupon of 3.625 percent and trading at $95. This bond is currently quoted at $125 and has a value of $6,633, for a net gain of 32.9 percent, plus my accumulated interest. The smaller gain of the 2008 TIPS is directly attributed to the shorter bond maturity.

Talk about flat and inverted yield curves! In the spring of 2000, I purchased an 8-year maturity bond yielding as much as a 30-year maturity bond. At times, there can be eBay-type action in fixed income securities. It is important to know how to identify both stock and bond opportunities as they occur.

I believe that only focusing on the equity side of investment opportunities is like looking on only one side of a dollar bill. Fixed income investing for equity investors need not be complicated, and there are many excellent educational tutorials available on the Internet for novice and more experienced individuals.

However, far too many investors prefer the harshness of castor oil over learning about bonds to improve their financial body and spirit.

George C. Fisher is a 30-year veteran in DSP/DRIP investing. He is author of All About DRIPs and DSPs (McGraw Hill, 2001) and The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002). Mr. Fisher is an avid dividend reinvestment advocate and utilizes the strategy with all dividend paying stocks, both at the broker and direct with the companies using their DRIP programs.

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