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Other fixed income investments

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Convertible bonds

Convertible bonds are another type of fixed income investment, but they're more of a cross between a bond and a stock.

Convertible bonds are issued by smaller, growing companies. The company needs money to grow, but for some reason doesn't want to issue stock at what could be a currently low price.

So the company issues convertible bonds. These bonds pay a lower interest rate than the going rate for corporate bonds of similar quality. But convertible bonds can be exchanged for new shares of the company's stock, usually at a favorable price and at the convertible bondholder's discretion.

Initially, because the company's stock price is below the conversion price, bondholders don't convert their bonds into shares. But, over time, if the company's stock increases, the bonds become more valuable.

So convertible bonds provide downside protection because they pay reasonably high current income, but they also have upside potential. If you have a large portfolio, you might want to place 15 percent of your bond money into a convertible bond mutual fund.

Preferred stock

Preferred stock, however, is one hybrid security that probably doesn't belong in an individual's portfolio. Preferred stock is really a fixed income investment and not an equity investment.

Most types of preferred stock offer high, fixed dividend payments, with little chance to benefit if the company prospers. In the hierarchy of claims on a corporation's assets, preferred stock is ranked above common stock but below bonds. Preferred stock gets the name "preferred" because of this ranking above common stock in bankruptcy claims.

Preferred stock is attractive to corporations

The fixed payments to preferred stockholders are classified as dividends, and not as interest payments, so the payments are not tax deductible by the issuing company. Since companies that receive dividend payments can exclude most of the dividend payments from their taxable income, preferred stocks are attractive to corporations.

The tax exclusion of dividends is open only to corporations, and is meant to reduce the effects of double or even triple taxation of dividends. The exclusion of preferred stock dividends means that preferred stock is more attractive to corporations than to individuals.

So unless you're a corporation, you probably shouldn't invest in preferred stock.

Miscellaneous fixed income plays

Although I'd recommend that you stick with bank CDs, bond mutual funds, or guaranteed investment contracts when you do your fixed income investing, there are other fixed income investments out there.

These include tax liens, adjustable rate mortgage funds or buying mortgages on your own. I'd recommend you stay away from these for the most part. They're riskier than you might think.

Although there are plenty of other esoteric fixed income investments out there, corporate and government bonds represent by far the largest part of the fixed income market.

Body text copyright 1997 by David Luhman