The information reflects the views of John Browning as of 4/21/08 and may change in response to changing circumstances and market conditions and may not actually come to pass. These comments are not necessarily representative of the opinions and views of the firm as a whole and do not purport to represent a complete picture of the marketplace nor the future performance of any Van Kampen product. The comments should not be construed as recommendations, but as an illustration of broader themes. Past performance is no guarantee of future results.The Van Kampen Unit Trust division has more than thirty years of experience analyzing and understanding the risks involved in the fixed income markets. Quality fixed income is widely recognized for its ability to provide ongoing cash flow Even during times of extreme market volatility. That having been said many investors are captivated by the powerful “siren song” of higher yields which brings to mind the old saying that “If it sounds too good to be true, it probably is.”
Many people assume that the fixed income market is inherently simple and safe. I would suggest that this is one of those notorious market myths. The fixed income market, in my opinion, often proves to be vastly more complicated and has more pitfalls than most other asset classes. It is easy for investors to believe they truly understand all the risks only to be blindsided later.
The following information describes just some of the potential rewards as well as some of the risks involved with investing in fixed income. As you read remember that fully understanding and analyzing the risks or partnering with someone who does may prove to be a wise choice.
The Rewards:
The positive side to the fixed income story is when used correctly with a good analysis and understanding of the risks, fixed income can be a very effective tool.
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Many successful investors will tell you investing over the long term is just as much about not losing money as it is about making money. Quality fixed income can act as a great way to protect your principal investment.
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Another great investment thesis is dollar cost averaging and keeping your portfolio asset allocations balanced. Fixed income may act as an effective tool by consistently taking the dividend payments from your fixed income Unit Trust and using it to invest and reallocate your portfolio.
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For some, the key thing to consider may be current income. Whether it is for a car payment or general living expenses, traditional fixed income Unit Trusts have historically provided a consistent reliable income stream. This income is easily calculated to provide a specific amount each month to meet specific needs over time.
Of course, one of the most important things you can do for long-term investment success is to have a balanced portfolio across all asset classes. Historical information shows that traditional fixed income prices have tended to move in the opposite direction of the equity markets over the long term. In addition, during periods of economic distress, traditional, quality, fixed income prices have historically tended to moved higher.
As we navigate through the uncertainty of the current markets, including traditional fixed income in a diversified package may provide an excellent and simple way to accomplish the objective of a balanced portfolio, current cash flow, dollar cost averaging, and/or preserving principal. Just remember fully understanding and analyzing the risks or partnering with someone who does may prove to be a wise choice.
The Risks:
I will just point out two of the most basic risks in fixed income:
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Credit risk seems to be the most obvious and is the risk that you will not receive your principal and interest payments on a timely basis due to an issuer default. The guarantee to receive your principal and interest payments is the reason why the government backing of Ginne Mae securities and treasuries so attractive. Credit risk also makes insured securities attractive as well. The insurance industry is currently having its own set of problems where their own credit quality is being called into question. Additionally, the rating agencies ability to accurately evaluate credit risk has been also been called into question. This makes a dedicated investment team of professionals watching over and picking the right credit risks, specific to your portfolio a valuable asset to have.
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Reinvestment risk, also known as interest rate risk or call risk is possibly not as obvious as credit risk but can be just as important to your long-term investment objectives. This risk is often misunderstood or completely overlooked. Reinvestment risk is the risk that current interest earned on an investment may not be reinvested at an interest rate equal to or greater than the invested money, which generated them. Many fixed income investors experienced reinvestment risk during the 1980’s as interest rates rose and they locked in high long term rates only to find when the bond matured they had to reinvest at a lower rate of return. With asset-backed securities this may be especially important as the underlying debt may often be prepaid at any time in incremental amounts which results in what is called extension and contraction risk.
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Extension risk occurs when rates move higher, less people may pay off their loans or will pay them down more slowly and investors then get less principal back and are not able to reinvest as much money at the new higher rates.
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Contraction risk occurs when rates move lower, more people may pay off their loans (refinance) or may pay them down more quickly and investors then get principal back more quickly and must reinvest they money at lower rates.
Sounds simple, Right? The problem is that there are myriads of events and circumstances that affect those broad risk categories and can combine to form a nearly infinite number of risk situations. A dedicated investment team that understands and analyses these risks may well prove to be an effective strategy in helping to achieve your long-term investment goals.
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