Many economists believe the U.S. economy is recovering from the deepest depression since the Great Depression. In sprite of the economist’s opinion, one must wonder if the economy recovery is real, or a simple head fake. In this article we’ll take a look at some hard facts.
The U.S. Economy
The Conference Board recently report the customer confidence index fell to 46.0 in February 2010, down from 55.9 in January.
The Labor Department reported jobless claims jumped the last week in February much higher than expected.
The Commerce Department report the first revision of the GDP for the 4th quarter rose to 5.9%. Good news except that inventory restocking made up 3.9% of the growth. This means that factors like consumer spending advanced far less.. The bad news is that consumer demand is not fueling growth. The evidence of this analysis will be evident in the coming quarter.
The Mortgage Bankers’ Association purchase index fell -7.3% to it lowest level since 1997. This index is a measure of applications through mortgage lenders and is considered an indicator of the strength of the housing market. The decline is a signal of housing market weakness.
The Commerce Department reported that new home sales declined -11.0% in January. This compounds December’s bad news when new home sales fell -7.6%.
The S&P Case-Schiller Price Index fell -3.1% compared to one year earlier. This dims hopes for a recovery in housing prices.
The commercial mortgage default rate jumped to 3.8% in the 4th quarter according to Real Capital Analytics, Inc. The default rate has more than doubled over the past year.
The FDIC reported that bank lending declined last year to the lowest level since 1942. This suggests that bank failures will rise in 2010. In 2009, 140 banks failed. Some 702 banks are at risk.
The National Association of Realtors reported that existing home sales fell -7.2% in January, following December’s drop of -16.7%.
The Commerce Department released the reading on the import/export prices. Import prices rose by 1.4% in January signaling that inflation may be picking up. This is up 11.5% from a year ago. Export prices also rose by 1.4% in January. The offsetting increases indicate a low growth in GDP.
Around the World
Japan, with $768.8 in U.S. securities is now the largest U.S. debt holder according to the Treasury Department. China was the largest, but after selling off $34 billion now holds around $755.4 billion in U.S. Treasuries.
The Office for National Statistics reported that jobless claims in the U,K. rose to 1.64 million in January, the highest level since 1997.
Greek labor unions held a second 24 hour strike to protest the governments’ budget cuts. The budget cuts represent efforts to reduce the deficit from 12.7% of GDP to a level acceptable to the European Union, and will result in salary freezes and bonus cuts.
Bank Rossii, Russia’s central bank, reduced its benchmark refinancing rate by .25% to 8.5% (a record low). The rate cut represents the central bank’s efforts to promote lending.
The Magyar Nemzeti Bank of Hungary is expected to lower its key interest rate to 5.75% (the lowest level since the fall of communism), according to a Bloomberg survey of economists. The rate cut is an attempt to stimulate economic growth.
Housing
Housing starts were up in January which would be good news if it weren’t for the glut of unsold homes already on the market. And if there wasn’t a shadow inventory of houses waiting to coming on the market.
While housing starts are increasing, new homes sales are down 7.6% in December. Recently RealtyTrac estimated that foreclosures will reach 4.5 million this year topping last year’s 2.82 million. And the Congressional Oversight Panel expects an additional 8 million to 13 million foreclosures over the next five years. New homes will sit unsold as the existing home market is cleared up, which won’t happen any time soon with the shadow inventory of homes nearing foreclosure entering the market.
The other problem: the government’s Home Affordable Modification Program simply isn’t working. Marking one year since its inception, the program has temporarily modified over 1 million mortgages, but permanently modified loans for only 116,297 homeowners, according to the Treasury Department. This is well below the program’s target of assisting up to 4 million troubled borrowers. The other problem with this program: for many homeowners, it is not enough. Many in the program still can’t make a mortgage payment (one third of homeowners in the program are delinquent). Ultimately, the program is delaying foreclosures, not preventing them.
With an increasing inventory of unsold homes, prices have one way to go: down. However, housing prices are still historically high, after adjusting for inflation.
Jobs
According to the Bureau of Labor Statistics, in December 43 states and the District of Columbia recorded unemployment rate increases. Until the unemployment starts a downward trend, an economy recovery is not possible.
Representative Debbie Wasserman Schultz, (D-20th District FL) in a recent newsletter to her constituents said the American Recovery and Reinvestment Act (stimulus) had created 112,000 jobs in FL. Florida received about $11.8 billion in stimulus funds which translates into paying about $105,500 to create each job. This cash outflow is not sustainable.
Florida's unemployment rate increased to 11.8 percent, the highest rate since May of 1975 reports the Agency for Workforce Innovation..
And things aren't looking brighter in the short term for Florida, Legislative economist Amy Baker predicted that Florida will lag behind the rest of the nation in recovering from the latest recession largely because of the state's housing surplus where there are more than a half million homes in foreclosure. Baker said Florida's unemployment will likely peak at 12 percent later this year.
Recovery?
A recovery may or may not be in our immediate future. Regardless, whatever the structure or timing of the recovery, many families will not detect a change in their own circumstances. So many jobs have been lost that the unemployment rate will remain high when and if the economy begins to rebound. Large numbers of still jobless Americans have exhausted their severance payments and unemployment benefits, keeping them under great strain even if the overall economy picks up. With a depleted saving backup, there is simply no room for slippage for many Americans.
This material was researched and written by David Snellen. © 2010 USA Living.com, Inc.
Sunday, March 7, 2010
Sunday, January 31, 2010
Bonds: What You Need to Know
Money is flowing into bond mutual funds at a dizzying pace this year. If the trend continues, bond funds will attract more than twice as much new money as they did in 2008 and a stunning 11 times more than investors are putting into stock funds this year.
Bond funds don’t ordinarily have greater inflows than stock funds, but may occur during periods of stock price volatility. This development is not surprising, but it is interesting nonetheless. Here’s why.
Interest rates are low and the Federal Reserve is likely to keep them low for the foreseeable future. As long as joblessness remains a problem, the Federal Reserve will be reluctant to raise interest rate targets and, in fact, has little reason to do so. Interest rates are one way to control the growth of an economy. When the economy is growing too fast and is at risk of high inflation, the Feds can slow it down with higher interest rates. An economy with high unemployment is unlikely to suffer from too-rapid growth and job creation would probably suffer from higher interest rates. Thus higher interest rates are not likely until the jobless rate begins to decline.
Bonds 101
But interest rates will inevitably go up. When interest rates rise, the value of existing bonds typically falls, this may adversely affect a bond fund’s performance. The face value of a bond and the current interest rate is an inverse relationship. And the reason is simple.
A bond is a debt instrument, usually tradeable, that represents a debt owed by the issuer to the owner of the bond. Most commonly, bonds are promises to pay a fixed rate of interest for a number of years, and then to repay the principal on the maturity date. In the U.S. bonds typically pay interest every six months (semi-annually), though other payment frequencies are possible. When interest rates are low the issuer is taking out a loan at a low fixed interest rate. This is no different than a person securing a long term mortgage at the low interest rate.
Bond Valuation
The value of any asset is the present value of its cash flows. So what happens to a bond paying 4% when the interest rate climbs to 8%? It will be valued at a discount to the face value to compensate the buyer for the lower than current interest rate. The longer the term to maturity the less it will be worth.
For example, let assume a new bond today that has:
1) 20 years to maturity
2) face value of $1,000
3) interest rate of 4% paid semiannually
This bond will pay to the holder 4% of its face value in interest each year. Since it pays semiannually, there will be 40 payments of $20 each and the $1,000 will be return at maturity (at the end of period 40). If current interest rates on a CD was 1.5%, then buying this bond for $1,000 may look like a good deal.
Let’s say over the next five years the economy improves, inflation kicks in and the interest rate paid on a CD is 8% and you are thinking about selling this bond. Unfortunately, this bond is only worth $777.63 because it represents an investment at a lower than current rate. A buyer will pay less than face value to compensate for the lower rate. Note, however, that the bond will still pay $40/year in interest and return the face value of $1,000 at maturity. (On the other hand, if the economy in the above example remains depressed and the current yield remains at 1.5%, the value of the bond will rise to $1,176.)
Investors who were smarting from their losses may have soured on stocks and decided the conservative return potential in the debt markets might be more appealing than the chance of suffering further losses in the equity markets. Realize, however that currently issuing bonds will be trading at a steep discount to their face value if interest rates rise.
It’s important to remember that you will receive the interest payment semiannually and the full face value at maturity regardless of current interest rates. The concern is the opportunity lost because you could invest your money somewhere else and earned a higher rate of return.
Bonds vs. Bond Funds
There is a big distinction between bonds and bond funds. An investor who buys individual bonds is typically interested in generating income and preserving principal. Investors who are careful to stagger the maturity dates in their bond portfolios may be able to further reduce the risk of having to reinvest a large percentage of their principal when rates are low. This was discussed in the October 2009 article titled “Managing Volatility with a Ladder”.
Bond funds generally employ a less conservative strategy by trading bonds before they mature in order to pursue gains by taking advantage of fluctuating interest rates. Bond funds will typically turnover their holding from 50% to over 200% each year. This may allow them to offer greater return potential, but sometimes with higher risk. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with the underlying bonds in the funds.
Bonds, bond funds and bond ETFs can play an important role in an investment portfolio, but they shouldn’t be thought of as a safe harbor to park money until the stock market settles down. Bond funds/ETFs are used in a portfolio to balance and compliment the equity investments. In addition, they should be a part of every investor’s portfolio because bond funds/ETFs produce monthly income.
Take for example, the Vanguard Long-Term Bond Index Fund (VBLTX). This fund holds a range of securities that approximates the performance of the long term (15 to 30 year) bond market. It opened in June 1996 and sold for about $9.58/share. It finished December 2009 selling for $11.56/share. In the mean time, it paid around 0.053 cents per share every month in interest payments. A purchase $10,000 of shares in June 1996 would be worth about $12,066 today and would have paid around $55/month, or about $660/year for a total of around $8,900 in interest payments. A nice addition to anyone’s portfolio. Note: The NAV of a bond fund/ETF is the only consideration when evaluating the fund’s performance. Dividends paid are not a consideration.
The decision to purchase a bond fund should be made based on your personal circumstances, such as your time horizon, risk tolerance, and personal goals. Bonds and bond funds come in a variety of forms which were discussed in the August 2009 newsletter in an article titled “Navigating the Bond Market”.
Exchange-traded funds and mutual funds are sold only by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Bond funds don’t ordinarily have greater inflows than stock funds, but may occur during periods of stock price volatility. This development is not surprising, but it is interesting nonetheless. Here’s why.
Interest rates are low and the Federal Reserve is likely to keep them low for the foreseeable future. As long as joblessness remains a problem, the Federal Reserve will be reluctant to raise interest rate targets and, in fact, has little reason to do so. Interest rates are one way to control the growth of an economy. When the economy is growing too fast and is at risk of high inflation, the Feds can slow it down with higher interest rates. An economy with high unemployment is unlikely to suffer from too-rapid growth and job creation would probably suffer from higher interest rates. Thus higher interest rates are not likely until the jobless rate begins to decline.
Bonds 101
But interest rates will inevitably go up. When interest rates rise, the value of existing bonds typically falls, this may adversely affect a bond fund’s performance. The face value of a bond and the current interest rate is an inverse relationship. And the reason is simple.
A bond is a debt instrument, usually tradeable, that represents a debt owed by the issuer to the owner of the bond. Most commonly, bonds are promises to pay a fixed rate of interest for a number of years, and then to repay the principal on the maturity date. In the U.S. bonds typically pay interest every six months (semi-annually), though other payment frequencies are possible. When interest rates are low the issuer is taking out a loan at a low fixed interest rate. This is no different than a person securing a long term mortgage at the low interest rate.
Bond Valuation
The value of any asset is the present value of its cash flows. So what happens to a bond paying 4% when the interest rate climbs to 8%? It will be valued at a discount to the face value to compensate the buyer for the lower than current interest rate. The longer the term to maturity the less it will be worth.
For example, let assume a new bond today that has:
1) 20 years to maturity
2) face value of $1,000
3) interest rate of 4% paid semiannually
This bond will pay to the holder 4% of its face value in interest each year. Since it pays semiannually, there will be 40 payments of $20 each and the $1,000 will be return at maturity (at the end of period 40). If current interest rates on a CD was 1.5%, then buying this bond for $1,000 may look like a good deal.
Let’s say over the next five years the economy improves, inflation kicks in and the interest rate paid on a CD is 8% and you are thinking about selling this bond. Unfortunately, this bond is only worth $777.63 because it represents an investment at a lower than current rate. A buyer will pay less than face value to compensate for the lower rate. Note, however, that the bond will still pay $40/year in interest and return the face value of $1,000 at maturity. (On the other hand, if the economy in the above example remains depressed and the current yield remains at 1.5%, the value of the bond will rise to $1,176.)
Investors who were smarting from their losses may have soured on stocks and decided the conservative return potential in the debt markets might be more appealing than the chance of suffering further losses in the equity markets. Realize, however that currently issuing bonds will be trading at a steep discount to their face value if interest rates rise.
It’s important to remember that you will receive the interest payment semiannually and the full face value at maturity regardless of current interest rates. The concern is the opportunity lost because you could invest your money somewhere else and earned a higher rate of return.
Bonds vs. Bond Funds
There is a big distinction between bonds and bond funds. An investor who buys individual bonds is typically interested in generating income and preserving principal. Investors who are careful to stagger the maturity dates in their bond portfolios may be able to further reduce the risk of having to reinvest a large percentage of their principal when rates are low. This was discussed in the October 2009 article titled “Managing Volatility with a Ladder”.
Bond funds generally employ a less conservative strategy by trading bonds before they mature in order to pursue gains by taking advantage of fluctuating interest rates. Bond funds will typically turnover their holding from 50% to over 200% each year. This may allow them to offer greater return potential, but sometimes with higher risk. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with the underlying bonds in the funds.
Bonds, bond funds and bond ETFs can play an important role in an investment portfolio, but they shouldn’t be thought of as a safe harbor to park money until the stock market settles down. Bond funds/ETFs are used in a portfolio to balance and compliment the equity investments. In addition, they should be a part of every investor’s portfolio because bond funds/ETFs produce monthly income.
Take for example, the Vanguard Long-Term Bond Index Fund (VBLTX). This fund holds a range of securities that approximates the performance of the long term (15 to 30 year) bond market. It opened in June 1996 and sold for about $9.58/share. It finished December 2009 selling for $11.56/share. In the mean time, it paid around 0.053 cents per share every month in interest payments. A purchase $10,000 of shares in June 1996 would be worth about $12,066 today and would have paid around $55/month, or about $660/year for a total of around $8,900 in interest payments. A nice addition to anyone’s portfolio. Note: The NAV of a bond fund/ETF is the only consideration when evaluating the fund’s performance. Dividends paid are not a consideration.
The decision to purchase a bond fund should be made based on your personal circumstances, such as your time horizon, risk tolerance, and personal goals. Bonds and bond funds come in a variety of forms which were discussed in the August 2009 newsletter in an article titled “Navigating the Bond Market”.
Exchange-traded funds and mutual funds are sold only by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Sunday, December 6, 2009
Asset Allocation Age
Many financial planners determine portfolio allocation based solely on the client’s chronological age. This may not be the best approach.
Most financial planners use some version of age based investment strategy. Client needs are different. The investment strategy for a 30 year old will be different than those of a 70 year old. The reasons are simple. An older person has less time to make up losses than a younger person. The older the investor, the less risk that investor should take.
A Simple, but Effective Approach
Many financial planners use an asset allocation model known as “Your Age in Bonds.” Very simply, whatever a person’s age is, that is the allocation in they should have in bonds. For example, for a 50-year old investor, the target for bonds and cash would be 50% of the portfolio value. The remainder of the portfolio should be in foreign and domestic stocks. The allocation is reviewed annually and adjustments made as the investor ages.
As simple as this concept is, it may not be practical for every person’s portfolio. Different people have different needs and their chronological age may not be the best way to determine portfolio allocation.
Age Contrasts
Everyone’s needs are different. A 30-year old is typically working, may be investing in the company 401(k) and has minimum saving. Market gyrations will have little impact on their net worth. They have many years of working and many opportunities to build a savings. So a 70/30 allocation in stocks and bonds would be a good start.
There is no such thing as a typical 55-year old investor. Some have accumulated significant wealth while other have few asset and significant debts. Some have 401(k)s, other’s have pension plans and some are relying on their own saving for retirement.
Family status is diversified also. Some have small families, no family or a large extended family. Some may have aging parent. While the “Your Age in Bonds” is a good asset allocation model, it cannot be applied to every investor.
Rather than use an investor’s chronological age as the primary yardstick, it makes more sense to use the investor’s allocation age to guide asset allocation. A person’s allocation age may be higher or lower than their chronological age. The allocation age takes individual life situations into account.
An example: Say a 65-year old couple has accumulated $2 million in liquid assets. They have two grown children who do not need financial support. The couple spends about $100,000 a year of which about $60,000 comes from pensions and social security. The balance of $40,000 comes from their savings account. A 35/65 stock/bond allocation would not be appropriate for this couple.
One approach would be to divide their assets into two portfolios. One portfolio of $1 million would be 35/65 stocks/bonds mix allocated to meet the income needs of the couple. The remaining $1 million is not likely to be needed by the couple and will pass to their children. So the second portfolio should be asset allocated to match their children’s age. Their average age is 35 so an appropriate allocation for this portfolio would be 65/35 which is the recipient’s allocation age. Instead of splitting the portfolio, the $2 million portfolio could be asset allocated as a 50/50 mix of stocks/bonds which is the couple’s asset allocation age.
Tale of Two Women
Assume a 55-year old woman is barely getting by. She has a small amount in her 401(k), has some housing debt and is caring for her aging parents. This person would have an asset allocation age of about 70 because she has a high cash flow risk. She is financially vulnerable and cannot afford to lose any sizable amount of her savings.
A second 55-year old woman has a pension plan, no housing debt and a large Roth account. Plus she expects to inherit a sizable estate from her parents. Her allocation age would be about 40 as she has no cash flow risk and no foreseen liabilities.
Two women, same age, but at vastly different asset allocation ages. The first woman should have at least 70% in bonds due to her financial situation. The second woman may have 60% in stocks and 40% in bonds because she is in much better financial shape and can tolerate more risk.
Chorological age is a good place to start with asset allocation. But the ultimate asset allocation is based on your asset allocation age which may higher, or lower than your chorological age.
Most financial planners use some version of age based investment strategy. Client needs are different. The investment strategy for a 30 year old will be different than those of a 70 year old. The reasons are simple. An older person has less time to make up losses than a younger person. The older the investor, the less risk that investor should take.
A Simple, but Effective Approach
Many financial planners use an asset allocation model known as “Your Age in Bonds.” Very simply, whatever a person’s age is, that is the allocation in they should have in bonds. For example, for a 50-year old investor, the target for bonds and cash would be 50% of the portfolio value. The remainder of the portfolio should be in foreign and domestic stocks. The allocation is reviewed annually and adjustments made as the investor ages.
As simple as this concept is, it may not be practical for every person’s portfolio. Different people have different needs and their chronological age may not be the best way to determine portfolio allocation.
Age Contrasts
Everyone’s needs are different. A 30-year old is typically working, may be investing in the company 401(k) and has minimum saving. Market gyrations will have little impact on their net worth. They have many years of working and many opportunities to build a savings. So a 70/30 allocation in stocks and bonds would be a good start.
There is no such thing as a typical 55-year old investor. Some have accumulated significant wealth while other have few asset and significant debts. Some have 401(k)s, other’s have pension plans and some are relying on their own saving for retirement.
Family status is diversified also. Some have small families, no family or a large extended family. Some may have aging parent. While the “Your Age in Bonds” is a good asset allocation model, it cannot be applied to every investor.
Rather than use an investor’s chronological age as the primary yardstick, it makes more sense to use the investor’s allocation age to guide asset allocation. A person’s allocation age may be higher or lower than their chronological age. The allocation age takes individual life situations into account.
An example: Say a 65-year old couple has accumulated $2 million in liquid assets. They have two grown children who do not need financial support. The couple spends about $100,000 a year of which about $60,000 comes from pensions and social security. The balance of $40,000 comes from their savings account. A 35/65 stock/bond allocation would not be appropriate for this couple.
One approach would be to divide their assets into two portfolios. One portfolio of $1 million would be 35/65 stocks/bonds mix allocated to meet the income needs of the couple. The remaining $1 million is not likely to be needed by the couple and will pass to their children. So the second portfolio should be asset allocated to match their children’s age. Their average age is 35 so an appropriate allocation for this portfolio would be 65/35 which is the recipient’s allocation age. Instead of splitting the portfolio, the $2 million portfolio could be asset allocated as a 50/50 mix of stocks/bonds which is the couple’s asset allocation age.
Tale of Two Women
Assume a 55-year old woman is barely getting by. She has a small amount in her 401(k), has some housing debt and is caring for her aging parents. This person would have an asset allocation age of about 70 because she has a high cash flow risk. She is financially vulnerable and cannot afford to lose any sizable amount of her savings.
A second 55-year old woman has a pension plan, no housing debt and a large Roth account. Plus she expects to inherit a sizable estate from her parents. Her allocation age would be about 40 as she has no cash flow risk and no foreseen liabilities.
Two women, same age, but at vastly different asset allocation ages. The first woman should have at least 70% in bonds due to her financial situation. The second woman may have 60% in stocks and 40% in bonds because she is in much better financial shape and can tolerate more risk.
Chorological age is a good place to start with asset allocation. But the ultimate asset allocation is based on your asset allocation age which may higher, or lower than your chorological age.
David Snellen
Registered Investment Advisor
USA Living Financial Group
954-302-3628
IRA to Roth Re-Characterization
The benefits of a Roth IRA can be summarized as tax-free income, no required distribution and ability to pass the account tax-free to heirs. The earnings on the contribution are returned to you tax-free and no penalty if you’re over 59 1/2 and otherwise meet the requirements for a qualified distribution. You can withdraw your contribution at any time without penalty. Unfortunately, households with a modified adjusted gross income of $100,000 or more were unable to have a Roth account. This about to change.
The ability to re-characterize an IRA to a Roth has always been available to people below the $100,000 gross income level. You will have a tax liability on the conversion amount which is due by April 15th of the following year. You will also have to wait five years and be over the age of 59 ½ before you can access the principal and growth tax/penalty-free.
What has changed is beginning January 1, 2010, any household at any income level can convert a traditional IRA to a Roth IRA. You will have to pay taxes on the conversion at your current rate. For example, if you are at the 25% tax level, on a $100,000 conversation you will be taxed $25,000. But if you convert in 2010, you’ll have the opportunity to recognize half the income in 2010 and the other half in 2011. In other words, you will have two years to pay the taxes on the conversion. The five year and 59 ½ rule will apply to the conversion.
Considerations
For many people, this is a great one-time opportunity to create future tax-free distributions. However, the conversion is not for everyone. Things to consider:
If you expect your tax rate to decline in the future, then it would make sense to forgo the conversation and just pay the tax on the IRA distribution. The closer you are to retirement and to taking withdrawals, the stronger this argument becomes. There is no guarantee however that your tax rate or tax liability will decline in the future even with a reduced income. With huge government spending, the deficit is growing rapidly which means some taxes will, in the future, be going up. Or the government could reduce the allowable deductions we now enjoy. Either way, the end result will effectively increase your tax rate. Most financial analysts expectitax rates to increase at some point in the future.
You should have the money available to pay the tax without raiding the IRA to do so. Using the IRA to pay the taxes is self-defeating. This may subject you to a 10% penalty and you would lose the tax-free growth on the money sheltered within the account. The need to pay the tax sooner and in much larger lumps is the major disadvantage of the IRA to Roth conversion. Fortunately, the conversion is not an all or nothing proposition. You can convert some of the IRA assets to a Roth while leaving the balance in the IRA. In other words, you can convert the amount for which you have the money on hand to pay the tax, not the entire IRA amount.
One idea would be to increase your payroll withholdings beginning in January 2010 and running through December 2011. Work with your CPA to estimate the total tax overpayment and then use that amount to pay the conversion tax. Remember you have two years to pay the tax, but the conversion goes to work for you immediately.
The government may attempt to touch Roth accounts. The end result is the government could realize a huge influx of income (taxes) over the next two years at the expense of future administrations. Future administrations may attempt to recoup some of the ‘lost’ revenue by taxing Roth withdrawals. This is not likely as it would be double taxation but they could remove the tax-free ability to pass the account onto your heirs. Or they could decide to tax the Roth earning. This would be an unpopular decision but there may be other creative ways the government could tap the Roth accounts. Although possible, I don’t think the government will attempt to touch Roth accounts in the foreseeable future.
The Best Approach
The best overall approach may be to transfer as must as you can afford into your Roth in 2010 and leave the balance in your IRA. You can always re-characterize portions of your IRA to your Roth at a future time if your gross income is less than $100,000. The only 2010 urgency is the removal of the gross income restriction and having the ability to spread the tax liability over a two year period. And then again, the government may extend the program or a modified version into 2011 and beyond.
All IRA to Roth re-characterizations are taxable events and will have to meet the five-year rule before the distributions will be tax-free. If you have a number of years before retirement, this can be a good retirement planning. If you’re already over 59 ½, you can take IRA distributions now, pay the tax and place the distribution in your Roth.
The Divide and Conquer Strategy
For most people, a partial IRA conversion is the best option because of the tax liability involved. Fortunately, creative planning can help you get the most mileage from a partial conversion. If you place the full conversion into a single Roth account, the tax effects of losses and gains are proportional to the account. But if you split the IRA conversion into multiple Roth accounts each with a single asset class, then you can use re-characterizations to take maximum advantage of the tax break. This strategy is available to you every year.
A Step by Step Example
Assumptions: You are in the 25% tax bracket and have $200,000 in an IRA. You have $5,000 in cash which you are willing to use to pay the tax on the conversion.
Step 1. January 2010: Convert the $100,000 in the IRA into five separate Roth accounts with each with $20,000 and invested in a single asset class. Asset classes could be high yield bonds, emerging markets, REITs, domestic small caps and foreign stocks. This is a temporary allocation and other asset classes could be used. The idea to achieve hyper-returns from one or more asset classes.
Step 2. April 15, 2011: Pay the $5,000 tax but file for an automatic extension on the return. This will give you until October 15, 2011 to file the final return.
Step 3. October 1, 2011: Review each Roth account and decide which one to keep. Then re-characterize the other four back to the IRA before October 15, 2011. The end result is you paid the $5,000 tax on the conversion, enjoyed 21 months of earnings and started the clock on tax-free withdrawals in January 2010.
What if all five Roth accounts decline in value? Simple, just re-characterize all five back to the IRA, file the tax return and get a refund of the $5,000. After 31 days, or at the beginning of the year after the original conversion, whichever comes later, you can once again re-characterize the traditional IRA to Roth IRAs, but with a lower tax liability. This strategy will provide you with a lot of tax planning flexibility.
Piles of Paperwork
The above strategy will require accurate record keeping. You will need to track the IRA and Roth accounts very carefully and document the money movement. Avoid using a single Roth account as the proportional allocations will be difficult to track.
If you want to push back portions of a combined Roth, the custodian will have to determine the amount of the portion conversion and any net income (or loss) allocable to the conversion. If the Roths are combined, you may be required to make up any losses. This is self-defeating so the easiest solution is to create separate Roth accounts.
The Roth you decide to keep should be re-allocated to a more effective diversification. After the five year waiting period, this Roth can be merged into the ‘master’ Roth without penalty.
The Divide and Conquer strategy can be used every year. The ideal situation would be to have five Roth accounts in the pipeline with one “graduating” each January and merged into the master Roth. Use remaining IRA amounts to create five more Roths. In December of the same year, pick the one you like best and send the rest back to the IRA. Repeat in January.
You can see the importance of accurate paperwork because you will be tracking up to 10 Roth accounts and the IRA account. With separate Roth accounts for each year, the paperwork trail will be easier to manage.
Summary
The upcoming Roth IRA conversion can be a golden opportunity for the right person. But it’s not for everyone. Feel free to contact me and I can help you with the pros and cons for your specific situation.
The ability to re-characterize an IRA to a Roth has always been available to people below the $100,000 gross income level. You will have a tax liability on the conversion amount which is due by April 15th of the following year. You will also have to wait five years and be over the age of 59 ½ before you can access the principal and growth tax/penalty-free.
What has changed is beginning January 1, 2010, any household at any income level can convert a traditional IRA to a Roth IRA. You will have to pay taxes on the conversion at your current rate. For example, if you are at the 25% tax level, on a $100,000 conversation you will be taxed $25,000. But if you convert in 2010, you’ll have the opportunity to recognize half the income in 2010 and the other half in 2011. In other words, you will have two years to pay the taxes on the conversion. The five year and 59 ½ rule will apply to the conversion.
Considerations
For many people, this is a great one-time opportunity to create future tax-free distributions. However, the conversion is not for everyone. Things to consider:
If you expect your tax rate to decline in the future, then it would make sense to forgo the conversation and just pay the tax on the IRA distribution. The closer you are to retirement and to taking withdrawals, the stronger this argument becomes. There is no guarantee however that your tax rate or tax liability will decline in the future even with a reduced income. With huge government spending, the deficit is growing rapidly which means some taxes will, in the future, be going up. Or the government could reduce the allowable deductions we now enjoy. Either way, the end result will effectively increase your tax rate. Most financial analysts expectitax rates to increase at some point in the future.
You should have the money available to pay the tax without raiding the IRA to do so. Using the IRA to pay the taxes is self-defeating. This may subject you to a 10% penalty and you would lose the tax-free growth on the money sheltered within the account. The need to pay the tax sooner and in much larger lumps is the major disadvantage of the IRA to Roth conversion. Fortunately, the conversion is not an all or nothing proposition. You can convert some of the IRA assets to a Roth while leaving the balance in the IRA. In other words, you can convert the amount for which you have the money on hand to pay the tax, not the entire IRA amount.
One idea would be to increase your payroll withholdings beginning in January 2010 and running through December 2011. Work with your CPA to estimate the total tax overpayment and then use that amount to pay the conversion tax. Remember you have two years to pay the tax, but the conversion goes to work for you immediately.
The government may attempt to touch Roth accounts. The end result is the government could realize a huge influx of income (taxes) over the next two years at the expense of future administrations. Future administrations may attempt to recoup some of the ‘lost’ revenue by taxing Roth withdrawals. This is not likely as it would be double taxation but they could remove the tax-free ability to pass the account onto your heirs. Or they could decide to tax the Roth earning. This would be an unpopular decision but there may be other creative ways the government could tap the Roth accounts. Although possible, I don’t think the government will attempt to touch Roth accounts in the foreseeable future.
The Best Approach
The best overall approach may be to transfer as must as you can afford into your Roth in 2010 and leave the balance in your IRA. You can always re-characterize portions of your IRA to your Roth at a future time if your gross income is less than $100,000. The only 2010 urgency is the removal of the gross income restriction and having the ability to spread the tax liability over a two year period. And then again, the government may extend the program or a modified version into 2011 and beyond.
All IRA to Roth re-characterizations are taxable events and will have to meet the five-year rule before the distributions will be tax-free. If you have a number of years before retirement, this can be a good retirement planning. If you’re already over 59 ½, you can take IRA distributions now, pay the tax and place the distribution in your Roth.
The Divide and Conquer Strategy
For most people, a partial IRA conversion is the best option because of the tax liability involved. Fortunately, creative planning can help you get the most mileage from a partial conversion. If you place the full conversion into a single Roth account, the tax effects of losses and gains are proportional to the account. But if you split the IRA conversion into multiple Roth accounts each with a single asset class, then you can use re-characterizations to take maximum advantage of the tax break. This strategy is available to you every year.
A Step by Step Example
Assumptions: You are in the 25% tax bracket and have $200,000 in an IRA. You have $5,000 in cash which you are willing to use to pay the tax on the conversion.
Step 1. January 2010: Convert the $100,000 in the IRA into five separate Roth accounts with each with $20,000 and invested in a single asset class. Asset classes could be high yield bonds, emerging markets, REITs, domestic small caps and foreign stocks. This is a temporary allocation and other asset classes could be used. The idea to achieve hyper-returns from one or more asset classes.
Step 2. April 15, 2011: Pay the $5,000 tax but file for an automatic extension on the return. This will give you until October 15, 2011 to file the final return.
Step 3. October 1, 2011: Review each Roth account and decide which one to keep. Then re-characterize the other four back to the IRA before October 15, 2011. The end result is you paid the $5,000 tax on the conversion, enjoyed 21 months of earnings and started the clock on tax-free withdrawals in January 2010.
What if all five Roth accounts decline in value? Simple, just re-characterize all five back to the IRA, file the tax return and get a refund of the $5,000. After 31 days, or at the beginning of the year after the original conversion, whichever comes later, you can once again re-characterize the traditional IRA to Roth IRAs, but with a lower tax liability. This strategy will provide you with a lot of tax planning flexibility.
Piles of Paperwork
The above strategy will require accurate record keeping. You will need to track the IRA and Roth accounts very carefully and document the money movement. Avoid using a single Roth account as the proportional allocations will be difficult to track.
If you want to push back portions of a combined Roth, the custodian will have to determine the amount of the portion conversion and any net income (or loss) allocable to the conversion. If the Roths are combined, you may be required to make up any losses. This is self-defeating so the easiest solution is to create separate Roth accounts.
The Roth you decide to keep should be re-allocated to a more effective diversification. After the five year waiting period, this Roth can be merged into the ‘master’ Roth without penalty.
The Divide and Conquer strategy can be used every year. The ideal situation would be to have five Roth accounts in the pipeline with one “graduating” each January and merged into the master Roth. Use remaining IRA amounts to create five more Roths. In December of the same year, pick the one you like best and send the rest back to the IRA. Repeat in January.
You can see the importance of accurate paperwork because you will be tracking up to 10 Roth accounts and the IRA account. With separate Roth accounts for each year, the paperwork trail will be easier to manage.
Summary
The upcoming Roth IRA conversion can be a golden opportunity for the right person. But it’s not for everyone. Feel free to contact me and I can help you with the pros and cons for your specific situation.
David Snellen
Registered Investment Advisor
USA Living Financial Group
954-302-3628
Thursday, November 5, 2009
Navigating the Bond Market
(Written September 2009)
Bonds are fixed income investments. In other worldsbond (purchased individually or via ETF or mutual fuis a debt security. In effect, you are loaning money togovernment, a municipality or a company in the expectation of receiving monthly, quarterly or semi-annually interest payments, in addition to return of the principal.
Bonds are subject to their own set of investment risks including reinvestment risk, interest rate risk and purchasing power (inflation) risk. These risks affect all forms of corporate, government and municipal bond issues. Government bonds however are not subject to default risk, that is, the risk that a creditor may seize the underlying collateral of a bond (if any) and sell it to recoup the principal. Also, government bonds do not have credit risk which is the risk that the issuer cannot make interest and principal payments.
The credit risk of a bond issuer can be determined by reviewing the credit rating assigned by the bond rating agencies, most notably the private firms of Standard & Poor’s and Moody’s. Both firms rate a corporate bond issue as either Investment Grade or Non-Investment Grade (Speculative) grade. The grade assigned is a judgment call so it is recommend you (or your investment advisor) do your own due diligence on the issuer.
An alternative to individual bonds are bond ETF or mutual funds. A bond ETF/Mutual funds is a portfolio of individual bonds that have similar credit ratings. For example, the Dodge & Cox Income fund (DODIX) has an Average Credit Quality of AA (high grade) and Yield of 5.72%. On the other hand the Vanguard High-Yield Corporate mutual fund (VWEHX) has an Average Credit Quality of BB (Speculative) with a Yield of 8.40%.
You will notice with these two examples that the less the quality of the bond, the higher the yield. This is because for a lesser creditworthy company to sell its bonds, it must offer an interest rate high enough to attract a buyer. Contrast the two examples with the iShares Barclay 1-3 Year Treasury ETF (SHY) with a yield of 3.16% but no credit risk.
Bonds should be a portion of every investor’s portfolio regardless of age. The only variables being level of acceptable risk and percentage of portfolio. As the investor ages, shifting toward a larger allocation of bonds along with a move toward less risk in the bond allocation is necessary.
Bond Options
Municipals Bonds – Issued by state and city governments who use the money to build schools, sewers or other high ticket items. Most municipal bonds are free from federal income taxes and state tax (if the investor lives in the state that issued the bond. Because of the tax advantage, munis have historically offered much lower yields than Treasury bonds. The SPDR Barclays Capital Municipal Bond (TFI – 3.88%), Fidelity Municipal Income (FHIGX – 4.31%) and Vanguard Interm-Term Tx-Ex (VWITX – 4.00%) are three funds in this classification.
Government agency bonds – Ginnie Mae, Fannie Mae and Freddie Mac issue bonds backed by the payments from mortgages. Since the federal takeover of Fannie and Freddie, their bonds are effectively guaranteed. Ginnie Maes are also government backed. The yields tend to be higher than Treasurys. The Vanguard GNMA (VFIIX - 4.61%), Payden GNMA (PYGNX – 4.88%), Fidelity Ginnie Mae (FGMNX – 4.65%) and other funds can provide exposure.
Treasury bonds and TIPS – The interest and principal are guaranteed by the government. The downside is the safety is paid for with lower yields. The yields on Treasury Inflation Protected Securities (TIPS) are designed to float with the inflation rate. iShares Barclay TIPS Bond (TIP – 4.68%) and SPDR Barclays Capital TIPS (IPE – 3.38%) are two ETFs that invest in TIPS.
High-grade corporate bonds – Corporate bonds generally have higher yields when compared to Treasurys. They are not risk-free but the bondholders are ahead of stockholders if the company runs into financial trouble. RidgeWorth Investment Grade Bond (STGIX – 4.28%) and iShares Barclays MBS Bond (MBB – 3.85%) are two plays in these bonds.
High-yield bonds – Often called ‘junk bonds’, these riskier cousins of high-grade corporates are issued by companies that have to pay higher interest rates to attract investors. These funds can be tempting because of the high yields, but remember they are paying higher yields for a reason. Two funds in this agenda are SPDR Barclays Capital High Yiled Bond (JNK – 13.25%) and T. Rowe Price High-Yield (PRHYX – 8.32%).
As with any investment, always read the prospectus and make sure you understand all the fees and expenses associated with a bond or bond fund purchases. High fees may cut into your returns.
Written by David Snellen
© 2009 USA Living Financial Group
Disclosure:
David Snellen and/or his clients may have a position in one or more of the quoted funds/ETFs.
All stated yields are as of July 15, 2009
Due to the market volatility of the past year, the yields shown may not represent a true picture of the yields available with this class of bonds.
Bonds are fixed income investments. In other worldsbond (purchased individually or via ETF or mutual fuis a debt security. In effect, you are loaning money togovernment, a municipality or a company in the expectation of receiving monthly, quarterly or semi-annually interest payments, in addition to return of the principal.
Bonds are subject to their own set of investment risks including reinvestment risk, interest rate risk and purchasing power (inflation) risk. These risks affect all forms of corporate, government and municipal bond issues. Government bonds however are not subject to default risk, that is, the risk that a creditor may seize the underlying collateral of a bond (if any) and sell it to recoup the principal. Also, government bonds do not have credit risk which is the risk that the issuer cannot make interest and principal payments.
The credit risk of a bond issuer can be determined by reviewing the credit rating assigned by the bond rating agencies, most notably the private firms of Standard & Poor’s and Moody’s. Both firms rate a corporate bond issue as either Investment Grade or Non-Investment Grade (Speculative) grade. The grade assigned is a judgment call so it is recommend you (or your investment advisor) do your own due diligence on the issuer.
An alternative to individual bonds are bond ETF or mutual funds. A bond ETF/Mutual funds is a portfolio of individual bonds that have similar credit ratings. For example, the Dodge & Cox Income fund (DODIX) has an Average Credit Quality of AA (high grade) and Yield of 5.72%. On the other hand the Vanguard High-Yield Corporate mutual fund (VWEHX) has an Average Credit Quality of BB (Speculative) with a Yield of 8.40%.
You will notice with these two examples that the less the quality of the bond, the higher the yield. This is because for a lesser creditworthy company to sell its bonds, it must offer an interest rate high enough to attract a buyer. Contrast the two examples with the iShares Barclay 1-3 Year Treasury ETF (SHY) with a yield of 3.16% but no credit risk.
Bonds should be a portion of every investor’s portfolio regardless of age. The only variables being level of acceptable risk and percentage of portfolio. As the investor ages, shifting toward a larger allocation of bonds along with a move toward less risk in the bond allocation is necessary.
Bond Options
Municipals Bonds – Issued by state and city governments who use the money to build schools, sewers or other high ticket items. Most municipal bonds are free from federal income taxes and state tax (if the investor lives in the state that issued the bond. Because of the tax advantage, munis have historically offered much lower yields than Treasury bonds. The SPDR Barclays Capital Municipal Bond (TFI – 3.88%), Fidelity Municipal Income (FHIGX – 4.31%) and Vanguard Interm-Term Tx-Ex (VWITX – 4.00%) are three funds in this classification.
Government agency bonds – Ginnie Mae, Fannie Mae and Freddie Mac issue bonds backed by the payments from mortgages. Since the federal takeover of Fannie and Freddie, their bonds are effectively guaranteed. Ginnie Maes are also government backed. The yields tend to be higher than Treasurys. The Vanguard GNMA (VFIIX - 4.61%), Payden GNMA (PYGNX – 4.88%), Fidelity Ginnie Mae (FGMNX – 4.65%) and other funds can provide exposure.
Treasury bonds and TIPS – The interest and principal are guaranteed by the government. The downside is the safety is paid for with lower yields. The yields on Treasury Inflation Protected Securities (TIPS) are designed to float with the inflation rate. iShares Barclay TIPS Bond (TIP – 4.68%) and SPDR Barclays Capital TIPS (IPE – 3.38%) are two ETFs that invest in TIPS.
High-grade corporate bonds – Corporate bonds generally have higher yields when compared to Treasurys. They are not risk-free but the bondholders are ahead of stockholders if the company runs into financial trouble. RidgeWorth Investment Grade Bond (STGIX – 4.28%) and iShares Barclays MBS Bond (MBB – 3.85%) are two plays in these bonds.
High-yield bonds – Often called ‘junk bonds’, these riskier cousins of high-grade corporates are issued by companies that have to pay higher interest rates to attract investors. These funds can be tempting because of the high yields, but remember they are paying higher yields for a reason. Two funds in this agenda are SPDR Barclays Capital High Yiled Bond (JNK – 13.25%) and T. Rowe Price High-Yield (PRHYX – 8.32%).
As with any investment, always read the prospectus and make sure you understand all the fees and expenses associated with a bond or bond fund purchases. High fees may cut into your returns.
Written by David Snellen
© 2009 USA Living Financial Group
Disclosure:
David Snellen and/or his clients may have a position in one or more of the quoted funds/ETFs.
All stated yields are as of July 15, 2009
Due to the market volatility of the past year, the yields shown may not represent a true picture of the yields available with this class of bonds.
Is the Worst Over?
(Written November 2009)
The stock and bond markets are indicating that we may have seen the bottom of this economic cycle. The markets are reacting to indication that the stimulus efforts may be working. Bad economic news comes less often and in many cases the numbers are improving. But is the worst over?
With the sharp rallies off the March 9th lows, the summer and fall seem to be giving way to a more somber view of a potential recovery.
Consumers continue to cope with near double digit unemployment and the ongoing recession while trying to salvage what they can of retirement and investment accounts. The U.S. auto industry operates as a former shell of itself, but manufacturing overall is showing some signs of stabilization. Banks and financial institutions still face pressures but posted substantial earnings recovery.
Economic data remains mixed and often contradictory. One must have faith in the ability of the U.S. economy to return to sustainable growth.
The tough part is the not knowing which way the economy and consequentially the stock market will move and over what length of time. No one has a crystal ball, but now being warier and wiser, we can look toward what’s on the horizon.
How It All Started
It’s hard to pinpoint the beginning of the financial crisis. The first signs appeared in late 2006 and 2007 when sub-prime mortgage lenders started going under. The government recognizes the problem and in 2007 began a series of moves to shortstop the growing number of mortgage defaults.
Through the fall of 2007 and into 2008, the government was actively injecting money into the banking system while simultaneously lowering the interest rate.
The Bank of America’s Jan 2008 purchase of Countrywide Financial, the country’s largest sub-prime lender, made BoA the nation’s largest mortgage lender. While mortgage defaults were in the news, this event put the issue on the front page and highlight for most Americans the seriousness of the mortgage defaults.
Then beginning in Jan 2008, banks began to fail. One in January, another one in March followed by two in May. JPMorgan Chase & Co. acquired The Bear Sterns Corporation in March 2008 at a fire sale price. And then the failure of Indymac Bank, on July 12th, 2008.
Many believe it was the failure of Indymac Bank that started the banking dominos to start falling. The failure of Indymac is widely blamed on Senator Chuck Schumer (D) New York who purposely leaked an internal memo on June 26th, 2008 calling into question Indymac Bank’s viability. The discloser resulted in an eleven day run on Indymac resulting in the withdraw of more than $1.3 billion dollars.
John Reich, the director of The Office of Thrift Supervision at that time directly placed the blame for the bank’s failure on the comments made in Senator Schumer’s letter. Indymac Bank was not a poster child of how to run a bank and may well have failed at a later date. And maybe not. We will never know. But at the time Indymac was the most expensive bank failure ever.
Blood was in the water and the Wall Street sharks began to circle Fannie Mae and Freddie Mac. Short sellers, who profit when the price of a stock falls, attacked these financial giants along with other large banks driving their stock price into the ground. One name that stands out is George Soro, the billionaire who broke the bank of England in late 1992 with his shorting the sterling. Soro takes major short positions in US and European stocks, the dollar and 10-year Treasuries. The book he published in April 2008 along with his many appearances on financial shows and written commentary help his positions become big winners.
And then came September 2008, the most harrowing month of all. Fannie Mae and Freddie Mac are placed under government control. Bank of America takes over Merrill Lynch and Lehman Brothers files for Chapter 11 bankruptcy. The consumer starts noticing things were not right and stopped spending which sent demand into a free fall. Washington Mutual Bank failed in September and twelve more would fail before the end of the year.
The U.S. stock market bottoms on March 9th, 2009 down 56.78% from the October 2007 high.
Getting Our Bearing
So where do we go from here? No one knows for sure except we do know that the business cycle and the economy move in a constant pattern of up and down cycles. If the pattern holds true then we should be looking at a gradual if uneven recovery. This will ultimately lead to yet another sump. Like waves on the ocean, you cannot prevent naturally occurring events.
But the one thing we did learn is that the world economies are much interwoven. The U.S. sells raw material and finished products to other countries who in turn sell us raw materials and their finished products. The U.S. is not likely to experience sustained consistent growth without the same occurring in other countries.
What we want to do is avoid overacting to the latest sentiment. Many investors now want a more actively managed portfolio which implies that somehow one can foresee which way the market will move. The best evidence that market timing is a bad idea is the market’s recent behavior. Very few people predicted the crisis. Of those who did, most have been predicting it for years. Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections or anticipating corrections than has been lost in the corrections themselves.
The Road Ahead
There are investment strategies to consider going forward. The first step is to look at your overall investment portfolio within the context of a financial plan. We shouldn’t be focusing on individual investments or the hot sectors.
We do want to hedge the potential inflation risk by considering precious metals and high yield bonds. Diversification is a technique to help reduce risk, but there is no guarantee that diversification will protect against a loss. When the boat is sinking it doesn’t matter which seat you are in. You will still get wet.
We shouldn’t depend solely on the U.S. economy to drive our portfolio. Having a position in specialty sectors like emerging markets, consumer stables, science and technology in additional to the U.S. overall market will help to ensure your portfolio has a chance of growth.
In this era of American economy, investors chart their courses. Consumers set aside more savings. Workers value their jobs more than ever. The greatest cause for optimism may be that we’re grinding through this recession. This is a good thing.
Written by David Snellen.
© 2009 USA Living.com, Inc.
The stock and bond markets are indicating that we may have seen the bottom of this economic cycle. The markets are reacting to indication that the stimulus efforts may be working. Bad economic news comes less often and in many cases the numbers are improving. But is the worst over?
With the sharp rallies off the March 9th lows, the summer and fall seem to be giving way to a more somber view of a potential recovery.
Consumers continue to cope with near double digit unemployment and the ongoing recession while trying to salvage what they can of retirement and investment accounts. The U.S. auto industry operates as a former shell of itself, but manufacturing overall is showing some signs of stabilization. Banks and financial institutions still face pressures but posted substantial earnings recovery.
Economic data remains mixed and often contradictory. One must have faith in the ability of the U.S. economy to return to sustainable growth.
The tough part is the not knowing which way the economy and consequentially the stock market will move and over what length of time. No one has a crystal ball, but now being warier and wiser, we can look toward what’s on the horizon.
How It All Started
It’s hard to pinpoint the beginning of the financial crisis. The first signs appeared in late 2006 and 2007 when sub-prime mortgage lenders started going under. The government recognizes the problem and in 2007 began a series of moves to shortstop the growing number of mortgage defaults.
Through the fall of 2007 and into 2008, the government was actively injecting money into the banking system while simultaneously lowering the interest rate.
The Bank of America’s Jan 2008 purchase of Countrywide Financial, the country’s largest sub-prime lender, made BoA the nation’s largest mortgage lender. While mortgage defaults were in the news, this event put the issue on the front page and highlight for most Americans the seriousness of the mortgage defaults.
Then beginning in Jan 2008, banks began to fail. One in January, another one in March followed by two in May. JPMorgan Chase & Co. acquired The Bear Sterns Corporation in March 2008 at a fire sale price. And then the failure of Indymac Bank, on July 12th, 2008.
Many believe it was the failure of Indymac Bank that started the banking dominos to start falling. The failure of Indymac is widely blamed on Senator Chuck Schumer (D) New York who purposely leaked an internal memo on June 26th, 2008 calling into question Indymac Bank’s viability. The discloser resulted in an eleven day run on Indymac resulting in the withdraw of more than $1.3 billion dollars.
John Reich, the director of The Office of Thrift Supervision at that time directly placed the blame for the bank’s failure on the comments made in Senator Schumer’s letter. Indymac Bank was not a poster child of how to run a bank and may well have failed at a later date. And maybe not. We will never know. But at the time Indymac was the most expensive bank failure ever.
Blood was in the water and the Wall Street sharks began to circle Fannie Mae and Freddie Mac. Short sellers, who profit when the price of a stock falls, attacked these financial giants along with other large banks driving their stock price into the ground. One name that stands out is George Soro, the billionaire who broke the bank of England in late 1992 with his shorting the sterling. Soro takes major short positions in US and European stocks, the dollar and 10-year Treasuries. The book he published in April 2008 along with his many appearances on financial shows and written commentary help his positions become big winners.
And then came September 2008, the most harrowing month of all. Fannie Mae and Freddie Mac are placed under government control. Bank of America takes over Merrill Lynch and Lehman Brothers files for Chapter 11 bankruptcy. The consumer starts noticing things were not right and stopped spending which sent demand into a free fall. Washington Mutual Bank failed in September and twelve more would fail before the end of the year.
The U.S. stock market bottoms on March 9th, 2009 down 56.78% from the October 2007 high.
Getting Our Bearing
So where do we go from here? No one knows for sure except we do know that the business cycle and the economy move in a constant pattern of up and down cycles. If the pattern holds true then we should be looking at a gradual if uneven recovery. This will ultimately lead to yet another sump. Like waves on the ocean, you cannot prevent naturally occurring events.
But the one thing we did learn is that the world economies are much interwoven. The U.S. sells raw material and finished products to other countries who in turn sell us raw materials and their finished products. The U.S. is not likely to experience sustained consistent growth without the same occurring in other countries.
What we want to do is avoid overacting to the latest sentiment. Many investors now want a more actively managed portfolio which implies that somehow one can foresee which way the market will move. The best evidence that market timing is a bad idea is the market’s recent behavior. Very few people predicted the crisis. Of those who did, most have been predicting it for years. Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections or anticipating corrections than has been lost in the corrections themselves.
The Road Ahead
There are investment strategies to consider going forward. The first step is to look at your overall investment portfolio within the context of a financial plan. We shouldn’t be focusing on individual investments or the hot sectors.
We do want to hedge the potential inflation risk by considering precious metals and high yield bonds. Diversification is a technique to help reduce risk, but there is no guarantee that diversification will protect against a loss. When the boat is sinking it doesn’t matter which seat you are in. You will still get wet.
We shouldn’t depend solely on the U.S. economy to drive our portfolio. Having a position in specialty sectors like emerging markets, consumer stables, science and technology in additional to the U.S. overall market will help to ensure your portfolio has a chance of growth.
In this era of American economy, investors chart their courses. Consumers set aside more savings. Workers value their jobs more than ever. The greatest cause for optimism may be that we’re grinding through this recession. This is a good thing.
Written by David Snellen.
© 2009 USA Living.com, Inc.
Managing Volatility with a Ladder
(Written October 2009)
During the past decade, income focused investors have faced a remarkable period of interest-rate volatility. In the past 10 years ending in 2008, the Federal Reserve adjusted the federal funds target rate, which influences the interest rates that consumers pay and bondholders earn, 41 times.
One way to help manage interest-rate risk and cash flow from income focused investment is to construct an investment ladder. This allows the investor to benefit when the rates are high and to help minimize the effect when rates are low. Implementing a ladder investment strategy is easy and can be done with bonds, CDs or annuities.
Step by Step Using Bonds
Bonds, which are debt obligations of the issuer, are issued with maturity dates ranging from a couple of years to 30 years or more. Interest payments are generally every six months with the face value of the bond due at maturity. The interest rate paid by bonds is established when the bond is issued. If interest rates later rise, the issuer will pay a below market interest rate. Conversely, if interest rates fall, the issuer is straddled with paying an above market rate interest rate.
Although the interest paid by the issuer will remain constant, the principal value of a bond may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investors seeking to achieve higher yields may also face a higher degree of risk. The interest earned may also be taxable at both the state and federal level.
To set up a six-year bond ladder, you would purchase five different bonds with maturity dates of two, three, four, five and six years, respectively. If these are new issue bonds, you will earn an interest rate close to the prevailing market rate. When the first bond matures after two years, you purchase a new six-year bond to keep the ladder intact. Each year when the bond matures, you simply purchase a new six year bond. If interest rates have risen, you benefit from having cash available to invest in a new bond at the higher rate. If interest rates have fallen, only a portion of the portfolio is subject to the lower rate.
An alternative to buying individual bonds is to invest in a bond mutual fund or ETF. Interest is paid monthly instead of semi-annually and you don’t have to worry about reinvestment interest rates.
Using Annuities
Annuities come is many flavors ranging from simple savings annuities to complex variable annuities. The ones we are interested in for an annuity ladder are the short term, no fee and no commission savings annuity. This type of annuity is available from several insurance companies. They can be purchased for various time periods ranging from two to ten years or more and generally have a minimum investment amount with $20,000 to $50,000 being common. These annuities offer a fixed rate of return for a fixed period and the purchaser has no market risk.
For example, in mid September 2009, a simple $100,000 2-year saving annuity contract can be purchased earning 1.75%. A $100,000 5-year saving annuity will earn 3.65%. You can buy this directly from the company with no fees, no commission or salesperson involved. You simply give them a check for $100,000 and in two years they give you back a check for about $103,560. The 5-year annuity would earn about $20,000. Unlike bonds and CDs, the tax on the interest earned on an annuity is deferred.
Constructing an annuity ladder is similar to that of a bond ladder, but you may be limited to the term lengths offered by a single company. For example, some companies offer 2, 5 and 10 year saving annuities. Others offer may offer 3, 5, 7 and 10 year terms.
The interest rate paid on an annuity contract is also influenced by the Federal Funds Target Rate. Like bonds, you will want to keep the ladder short with five to six years probably being the limit. To construct a two-year annuity ladder, purchase a two-year annuity this year and one year later purchase another two-year annuity. When the first one comes due, you may be able to do a 1031 exchange into another two-year annuity which may be paying a higher rate of guaranteed return. The 1031 exchange will allow you to defer the tax on the interest earned.
If a company allows for a three-year annuity contract, the ladder is constructed over a three year period. Or you could build a five year ladder by buying a five-year contract every year for five years. The longer the ladder the more stability the annuity ladder will offer but may subject you to interest rate risk.
Using CDs
Constructing a CD ladder is very similar to the bond and annuity ladder but with more choices. Term lengths on CDs range from three months to five years. In mid-September 2009, the highest rate available on a one-year CD is 2.15% APY.
To construct the CD ladder, buy five separate CDs with maturity dates of 1, 2, 3, 4 and 5 years. As the first one matures reinvest in a new five-year CD. Unlike annuities, you will pay the tax on the interest earned each year even if the money earned will not be received until the CD matures.
With CDs it pays to shop around. You may purchase the CD from practically any bank located anywhere within the USA. Interest rates vary widely between banks with a high today of 2.15% APY down to a low of 1.25% APY. You can find current rates on www.bankrate.com. It may also pay to call the bank directly to request quotes or check the bank’s Web site.
There is no trick to CD laddering. Only due diligence is required in order to minimize risks. You may pay a surrender charge if you cash in a CD before its maturity.
Income investing using a ladder strategy can help provide stability during periods of interest-rate volatility. Remember to read all the fine print before purchasing.
Where to Use a Ladder
All three ladders will create taxable income so it would be wise to consider which investment vehicle: a Traditional IRA, Roth IRA or Saving Account would be the most appropriate. The Roth IRA would by far be the best location because all income is receive tax free after you reach 59 ½. It would not make sense to place an annuity ladder in a Traditional IRA. An IRA already has deferred tax status. It’s a duplication of effort. Both the bond and CD ladder would fit nicely in any of the three investment vehicles.
Written by David Snellen
© 2009 USA Living Financial Group
During the past decade, income focused investors have faced a remarkable period of interest-rate volatility. In the past 10 years ending in 2008, the Federal Reserve adjusted the federal funds target rate, which influences the interest rates that consumers pay and bondholders earn, 41 times.
One way to help manage interest-rate risk and cash flow from income focused investment is to construct an investment ladder. This allows the investor to benefit when the rates are high and to help minimize the effect when rates are low. Implementing a ladder investment strategy is easy and can be done with bonds, CDs or annuities.
Step by Step Using Bonds
Bonds, which are debt obligations of the issuer, are issued with maturity dates ranging from a couple of years to 30 years or more. Interest payments are generally every six months with the face value of the bond due at maturity. The interest rate paid by bonds is established when the bond is issued. If interest rates later rise, the issuer will pay a below market interest rate. Conversely, if interest rates fall, the issuer is straddled with paying an above market rate interest rate.
Although the interest paid by the issuer will remain constant, the principal value of a bond may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investors seeking to achieve higher yields may also face a higher degree of risk. The interest earned may also be taxable at both the state and federal level.
To set up a six-year bond ladder, you would purchase five different bonds with maturity dates of two, three, four, five and six years, respectively. If these are new issue bonds, you will earn an interest rate close to the prevailing market rate. When the first bond matures after two years, you purchase a new six-year bond to keep the ladder intact. Each year when the bond matures, you simply purchase a new six year bond. If interest rates have risen, you benefit from having cash available to invest in a new bond at the higher rate. If interest rates have fallen, only a portion of the portfolio is subject to the lower rate.
An alternative to buying individual bonds is to invest in a bond mutual fund or ETF. Interest is paid monthly instead of semi-annually and you don’t have to worry about reinvestment interest rates.
Using Annuities
Annuities come is many flavors ranging from simple savings annuities to complex variable annuities. The ones we are interested in for an annuity ladder are the short term, no fee and no commission savings annuity. This type of annuity is available from several insurance companies. They can be purchased for various time periods ranging from two to ten years or more and generally have a minimum investment amount with $20,000 to $50,000 being common. These annuities offer a fixed rate of return for a fixed period and the purchaser has no market risk.
For example, in mid September 2009, a simple $100,000 2-year saving annuity contract can be purchased earning 1.75%. A $100,000 5-year saving annuity will earn 3.65%. You can buy this directly from the company with no fees, no commission or salesperson involved. You simply give them a check for $100,000 and in two years they give you back a check for about $103,560. The 5-year annuity would earn about $20,000. Unlike bonds and CDs, the tax on the interest earned on an annuity is deferred.
Constructing an annuity ladder is similar to that of a bond ladder, but you may be limited to the term lengths offered by a single company. For example, some companies offer 2, 5 and 10 year saving annuities. Others offer may offer 3, 5, 7 and 10 year terms.
The interest rate paid on an annuity contract is also influenced by the Federal Funds Target Rate. Like bonds, you will want to keep the ladder short with five to six years probably being the limit. To construct a two-year annuity ladder, purchase a two-year annuity this year and one year later purchase another two-year annuity. When the first one comes due, you may be able to do a 1031 exchange into another two-year annuity which may be paying a higher rate of guaranteed return. The 1031 exchange will allow you to defer the tax on the interest earned.
If a company allows for a three-year annuity contract, the ladder is constructed over a three year period. Or you could build a five year ladder by buying a five-year contract every year for five years. The longer the ladder the more stability the annuity ladder will offer but may subject you to interest rate risk.
Using CDs
Constructing a CD ladder is very similar to the bond and annuity ladder but with more choices. Term lengths on CDs range from three months to five years. In mid-September 2009, the highest rate available on a one-year CD is 2.15% APY.
To construct the CD ladder, buy five separate CDs with maturity dates of 1, 2, 3, 4 and 5 years. As the first one matures reinvest in a new five-year CD. Unlike annuities, you will pay the tax on the interest earned each year even if the money earned will not be received until the CD matures.
With CDs it pays to shop around. You may purchase the CD from practically any bank located anywhere within the USA. Interest rates vary widely between banks with a high today of 2.15% APY down to a low of 1.25% APY. You can find current rates on www.bankrate.com. It may also pay to call the bank directly to request quotes or check the bank’s Web site.
There is no trick to CD laddering. Only due diligence is required in order to minimize risks. You may pay a surrender charge if you cash in a CD before its maturity.
Income investing using a ladder strategy can help provide stability during periods of interest-rate volatility. Remember to read all the fine print before purchasing.
Where to Use a Ladder
All three ladders will create taxable income so it would be wise to consider which investment vehicle: a Traditional IRA, Roth IRA or Saving Account would be the most appropriate. The Roth IRA would by far be the best location because all income is receive tax free after you reach 59 ½. It would not make sense to place an annuity ladder in a Traditional IRA. An IRA already has deferred tax status. It’s a duplication of effort. Both the bond and CD ladder would fit nicely in any of the three investment vehicles.
Written by David Snellen
© 2009 USA Living Financial Group
Subscribe to:
Posts (Atom)