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Wednesday, March 9, 2011


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FIXED INCOME AND INTEREST RATES: In talking to my 23 year-old son, Ryan, about a certain preferred stock, I realized that he did not understand interest rates. And in talking to other subscribers, I've been surprised to learn how many subscribers shared Ryan's er ? lack of understanding about rates.

So here goes. Let's take a preferred stock that pays a fixed dividend of $2.50 annually. Year in and year out that preferred stock will pay $2.50. But the price of the stock itself will fluctuate. One month the stock will sell for 35 dollars, a year later it will sell for 40, and five years later it will sell for 27 dollars. But the stock will always pay the same amount, $2.50 a year.

Then why does the market price of this stock fluctuate? The price of this preferred stock fluctuates because it is influenced by prevailing outside interest rates.

One major factor in changing interest rates is inflation. Inflation is brought on by governments that create money. If too much money is created by the Federal Reserve, then those excess dollars drive up the price of goods. As the price of goods rises, it requires MORE DOLLARS to buy the same items. This is price inflation. In price inflation it costs you $2.00 to buy a certain loaf of bread. Six months later it costs you $2.25 to buy that same loaf of bread.

Buyers of fixed income securities are not protected when inflation arrives. Unlike common stocks, which theoretically can raise their dividends during inflationary times, the buyer or owner of the preferred stock (discussed above) cannot raise its dividend. Thus, the price of that preferred stock, which pays a steady $2.50, will suffer during inflation.

The preferred stock will not be able to raise its dividend during inflation so how does it adjust? It adjusts by changing its price on the open market.

As inflation increases, the preferred stock will decline in price. It will decline because that fixed dividend of $2.50 is worth less and less in terms of purchasing power. Let's say the price of the stock is 35 on the open market. At that price the stock will yield 7.14% ($.50 divided by 35). Next, inflation heats up and the price of the stock drops to 30. At 30, still with that same fixed $2.50 dividend the yield rises to 8.3% ($2.50 divided by 30). Thus the new buyer receives increased protection against inflation because he's getting a higher yield for his money.

But then a recession sets in and inflation drops to almost zero. That $2.50 dividend without inflation is worth a lot more. The stock rises in price to 40 dollars. At a price of 40 dollars, the same stock with the same $2.50 dividend drops in yield to 6.25% ($2.50 divided by 40).

So you see that we're dealing with a preferred stock that always pays the same $2.50 dividend but its price varies based on the state of inflation in the nation and thus the state of prevailing interest rates.

Question: How does the person who owns a slew of this preferred stock protect himself against inflation? The only way is through compounding. He must continually reinvest that $2.50 dividend in more of the preferred stock. This compounding process will probably outpace inflation over the years.

But he must continue to compound, or to reinvest. Otherwise, if inflation continues and the person spends the $2.50 dividend instead of reinvesting it, he's going to lose out since his original investment will be worth less and less as the years go by. His investments will be worth less and less because that fixed $2.50 dividend will buy him less and less in terms of goods and services.

By the way, I picked a preferred stock as an example in this piece. But you can substitute a bond for the preferred and the rationale remains the same. For more on compounding, read "Rich Man, Poor Man" on this same site.

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