As investors, we hear a lot about investment diversification. Furthermore, there is an old saying: no one should put “all of their eggs in one basket”. Why?
Because investment diversification reduces the risk of a large loss in one holding wiping out an entire portfolio.
TWO PRIMARY FORMS OF INVESTMENT DIVERSIFICATION
The two most typical forms of investment diversification definitions we hear about are:
- International diversification, and
- Diversification across asset classes
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INTERNATIONAL INVESTMENT DIVERSIFICATION
There is money to be made from investments all over the world. Rather than just your home country. International diversification addresses that concept.
ASSET CLASS INVESTMENT DIVERSIFICATION
Diversification across asset classes focuses on the investor’s risk tolerance. Most importantly, no tolerance for loss of your capital? You should stick to cash and short term bonds. Opposite, do you want more potential return and are risk tolerant? Then, put some money in small capitalization growth stocks across the globe.
A THIRD FORM OF INVESTMENT DIVERSIFICATION
I think of diversification in a third way. That is, diversifying up and down the corporate capital structure.
As an accounting teacher, I tell my students that for every asset a company buys, they must finance it in some way. Especially relevant, they finance each asset within their capital structure. As a result, corporate capital consists of liabilities and equity.
As investors, we can participate in the profits of a company by investing our hard earned money. We can also participate in all forms of corporate financing up and down the capital structure of businesses.
Here are several examples.
Short-Term Floating-Rate Demand Notes
Do you want to squeeze a little more return from your liquid cash holdings? Many companies issue these notes direct to private investors. They look and act like money market mutual funds with check writing privileges. In reality, you are investing in ultra-short term unsecured notes of the company.
While taking on single company risk with your money, you are rewarded with a higher interest rate. Normally a higher rate than the typical money market fund or savings account. Some well-known companies offer these notes like Caterpillar Financial Services, Duke Energy and Ford Motor Credit Corp to name a few.
Many companies finance their capital requirements through bank loans. These typically take the form of senior, floating rate debt.
Senior means the bank has a security interest in specific assets of the company if the company can not repay the loan. Floating rate means the interest rate changes frequently based on the current level of interest rates.
Hence, bank loans are like a floating rate mortgage on your home. The bank holds a security interest in the property if you default. And, they adjust your interest rate as market rates change.
As an investor, by resetting the interest rate on a periodic basis, your potential loss of principle in a rising interest rate environment is reduced. And, unlike more traditional notes and bonds, the investor’s interest payments rise along with market based rates.
The best way to access bank loans is through a fund or ETF. One of my favorite mutual funds in this area is the Fidelity Floating Rate High Income Fund (FFRHX). The expense ratio is a little higher than I would like, but I think active management can pay off in this area. Why? Many companies that use bank loans tend to have more debt. Consequently, they can be more risky.
In exchange for an investor’s cash, bonds are quite simply a promise to pay the bond holder a series of fixed interest payments during the life of the bond. In addition, a bond includes a promise to pay back the principle when the bond matures.
Bonds come in various maturities ranging from a few years to 30 years or more. In addition, they can have special features like being callable at an earlier date than maturity. Or, be convertible into the company’s stock.
Bonds carry more interest rate risk than bank loans since their interest rate is fixed. As a result, a bonds market value will move in an inverse relationship with market interest rates.
In contrast, bond value will move in a direct relationship with the company’s credit score. In other words, a lower credit score means a lower market price for the company’s bonds and vice versa. These risks can be reduced by buying individual bonds of credit worthy companies and holding them to maturity.
You can purchase individual bonds through your broker or by purchasing a mutual fund or ETF. I prefer the ETF route. You can’t go wrong with an ETF from Vanguard. Low cost and instant diversification can be achieved from the Vanguard Intermediate-Term Corporate Bond ETF (VCIT).
Preferred stock is a hybrid security that has a mix of bond and common stock characteristics. The investor doesn’t have the upside potential like common stock. Rather, the investor usually receives a hefty dividend yield. In addition, the investor receives preferential treatment above common stock holders on the receipt of those dividends.
Banks, insurance companies and utilities are big issuers of preferred stock. Like bonds, you can buy individual company issues through your broker or invest through mutual funds and ETFs. The I Shares US Preferred Stock ETF (PFF) is one example of a low cost fund with many preferred stock holdings.
By owning the common stock of a company, you are part owner in that business. And, participate in all the potential rewards and risks that go with ownership.
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WRAPPING IT UP
Review your investment holdings periodically. And when you do, don’t forget about good investment diversification practices. Take a look at all the ways businesses finance their cash needs through their capital structure. See if any of these financial instruments should have a larger place in your portfolio:
- Short-Term Floating-Rate Demand Notes
- Bank Loans
- Preferred Stock
- Common Stock
Do you diversify across the entire corporate capital structure? Do you have a different investment diversification strategy? In addition, are there other forms of corporate financing you invest in but are not discussed here?
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