Exactly What is a Bond?

Corporate and government entities issue bonds as a way of borrowing money. Investors purchase bonds (lend money) in exchange for interest payments and the promise that the loan will be repaid in the future. A typical bond specifies the date when the loan will be repaid (the maturity date), and the amount of interest to be paid every six months until the bond matures (the coupon). A bond’s coupon does not change, which is why bonds are frequently referred to as “fixed-income” investments. As bond purchasers are only loaning money, they have no rights of ownership in the entity borrowing the money.

The holder of a bond is paid its face value (usually $1,000) on the maturity date. A bond purchaser can usually sell the bond to another investor before the maturity date, but in doing so, gives up the right to receive coupon payments. The market price of a bond is determined by comparing the coupon rate of the bond with that of other bonds with similar risks. If the coupon rate is lower than that of other bonds, the bond will likely sell at discount (less than $1,000). If the bond is currently paying a higher coupon than that of other bonds, the bond will likely sell at a premium (more than $1,000). Often, investors are willing to pay more than the face value of the bond in exchange for receiving a higher coupon.

While bonds are typically considered to be a low-risk investment, they have several types of investment risk. Interest rate risk is the risk associated with a decline in the value of a bond as interest rates rise. Since coupons are fixed, existing bonds will be worth less if interest rates rise because newer bonds will offer higher coupons.

Default risk refers to the possibility that a bond issuer will not be able to make interest payments or repay the bond. To minimize this risk, pay attention to a bond’s rating, which is an evaluation of the entity’s creditworthiness. If an entity’s credit is shaky, its bonds are often referred to as "junk bonds."

Call risk is the possibility that a bond issuer could prepay the loan. When interest rates decline, entities often pay off their loans and then issue new debt at lower interest rates. When this happens, investors must reinvest their principle, likely at a lower interest rate.

Lastly, purchasing power risk refers to the possibility that interest and principle payments will not be as valuable due to the effects of inflation. Again, coupon payments are fixed, so if inflation increases, coupon and principle payments will purchase less.

A New Blogging Concept

Over the next month, I’ll be posting a blog entry every day. Each post will describe a common financial term in what I hope to be casual and understandable language. The premise of this activity is that people should never invest in something they don’t understand. For example, would you invest in a machine that prevented people from aging? Such an invention could be very lucrative. Everyone on the planet could use that, and would likely pay handsomely for such a machine. However, would it be a good idea to invest in the machine without understanding how it worked? Probably not.

First, it sounds like the type of machine wherein much could go wrong, so it would be a good idea to familiarize oneself with the risks of using the machine. Second, a machine that sounds too good to be true likely is. We should understand the details of the machine so we don’t get scammed. Lastly, what are the opportunity costs of using the machine? If we live forever, are we going to miss out on some unbelievably great after-life?

I’ve realized that many of the commonly used terms in the financial world are not clearly understood by people outside the profession (and in many cases, even by “financial advisors”). There are the abbreviations: IRA, SEP, ETF, S&P, and REITS. There are the numbers: 401k, 403b, 529, rule of 72. Do you understand the various investment options available: bonds, preferred stocks, derivatives, hedge funds, annuities? Should we really be investing in any of these tools if we don’t understand them? Check back each day for a short explanation of these key financial terms.

Lastly, if there are any items or issues you would like defined, please drop me a note. If you are unclear on something, there are many people who would benefit from information relating to your concern.

Supercharge Your 401k

New research shows 401k plan participants would be well-served to receive the services of a fee-only independent financial advisor. A Charles Schwab study revealed that 401k participants who sought professional assistance in allocating their assets earned a significantly greater rate of return than those who did not. The data examines 2006 returns and is broken down by age group.

The study reveals the significant value-added benefits 401k plan participants receive when they are educated regarding the impact of risk, return, time and diversification. Additional value was found to be added by financial advisors who persistently rebalanced a globally diversified portfolio.

Add fuel to your 401k today! Contact me to schedule a complimentary consultation where we’ll identify high-quality investment options and design a diversified portfolio.

Monday Update

Wall Street has had a rough day after the Chicago Board of Trade's Volatility Index (VIX) soared 12.5 percent to a measure of 31.49. Traditionally, a VIX measurement above 30 indicates an anticipated rise in the volatility of market prices. Of course, high volatility is usually viewed as a bearish sign and frequently leads to lower stock prices. However, for perspective it is useful to remember that the VIX topped out at just below 90 last November, so don't feel the need to liquidate your nest egg just yet.

Recharacterizing a Roth Conversion

When a traditional IRA is converted into a Roth account, the transaction is treated as a taxable distribution from the traditional IRA, followed by a contribution of the distributed amount to a Roth IRA. Such a conversion triggers an income-tax bill based on the traditional IRA's value on the conversion date.

If a conversion took place in early 2008, the resulting Roth IRA is now most likely worth considerably less than than it was on the conversion date. However, the tax bill is based on the value of the assets when the conversion took place, which means a tax liability will exist on money that has since been lost.

Thankfully, that ill-advised Roth conversion can be reversed. In fact, recharacterizing the conversion makes it like the conversion never happened, and as a result, that inflated conversion tax bill will also disappear. Conversions can be recharacterized until October 15th of the year following the transaction.

However, converting a traditional IRA to a Roth IRA can still be an appropriate strategy if the timing is right. After recharacterizing, there is a timing restriction as to when the account can be reconverted to a Roth IRA. An investor must wait 30 days after recharacterizing before reconverting.

As always, you should speak with a fee only, independent financial planning professional to make sure this investment strategy is appropriate for your individual circumstances.

Minimize Your Tax Bill

When considering converting your traditional IRA into a Roth IRA the first question you should ask is: Do you anticipate being in a lower, higher or the same tax bracket during retirement? If retirement withdrawals or other sources of income will keep you in the same or push you into a higher tax bracket, why not pay taxes on your retirement account now so you can enjoy the benefits of a lower tax rate? This is exactly what a Roth conversion allows you to do. Here are three more tax reasons to consider:

1. Tax rates are incredibly low by historical standards (the highest tax rate, which has been as high as 92% in the past, is currently 35%). Most experts anticipate tax rates to increase in the near future in order for the government to fund liabilities such as Medicare, Medicaid, social security, and the presidential administration's economic stimulus package. If an investor expects to remain in the same or a higher tax bracket upon retiring, it makes sense to convert traditional IRAs to Roth IRAs now, pay taxes at lower anticipated rates and enjoy tax-free growth going forward.

2. After the recent market decline, investors will only need to pay taxes on today's deflated values, which would be significantly more cost-efficient than paying taxes on 2007 investment values. Would you rather pay taxes on a highly appreciated asset, or an asset with a greatly reduced value? Converting after asset values have dropped 40% will minimize the tax bill.

3. Taxes have already been paid on Roth assets, so the government does not require minimum required distributions (RMDs) from these accounts after the investor reaches age 70.5. This enables the money to continue to grow tax deferred for as long as possible. Additionally, at death, Roth assets pass to heirs tax free, whereas traditional IRAs will be accompanied by a tax liability.

Other Factors
Keep in mind that in 2009, only individuals with a modified adjusted gross income (MAGI) of less than $100,000 can convert an IRA to a Roth IRA. However, this income limit will be waived in 2010. Additionally, investors who convert in 2010 will have the option of splitting the tax bill from the conversion between 2011 and 2012 (however, we don't know what tax rates will look like during these years, so this may or may not turn out to be a good deal). When converting, ALWAYS pay the tax liability from another source of income in order to keep as much money growing tax-free as possible. Lastly, be conscious of IRA conversion distributions lifting you into a higher tax bracket. An investor can partially convert an IRA during multiple years in order to avoid having a large infusion of income in a single year. Of course, you should speak with a financial planner to ensure this strategy is right for your situation.

What if you had the unfortunate timing of converting your IRA to a Roth IRA in early 2008, and now you have to pay taxes on the high value of your assets when you sold them as opposed to paying taxes only on their low current value? What if you are concerned about converting now only to see the value of your investment drop in the coming months? Check back later this week to learn a strategy that offers protection from these possibilities.

Fee-Based vs Fee-Only

Yesterday, my mother called to inform me that Suze Orman's book had an incorrect definition of what a fee-only planner is. My mom was wondering why Mrs. Orman's definition of fee-only was so different from what I do. When I read Mrs. Orman's book, I quickly realized the issue. My mother had confused the phrase "fee-only" with "fee-based." Even my own mother, who I speak to about my practice every week, had been tricked.

To be clear, "fee-only" financial planners CANNOT accept commissions or compensation from the products they recommend to clients. We are compensated only by our clients, and our compensation is the same regardless of the products we recommend. This allows us to truly represent our clients, not an insurance or brokerage firm that signs our paycheck. Consequently, we can focus on doing what is in the absolute best interest of our client without worrying about maximizing our own compensation. Lastly, fee-only financial planners have a fiduciary responsibility to always do what is in the client's best interest. Working with a fiduciary is critical.

"Fee-based" financial planners may have the ability to collect fees from their clients, but they still have the ability to collect commissions from the products they sell. Thus, fee-based planners may charge the client a fee for managing assets, but then may also collect commissions from a mutual fund that charges the owner of the fund ridiculously high fees. Additionally, fee-based advisors have the ability to collect commissions on insurance and annuities policies which are sometimes not in the client's best interest. Fee-based advisors are only held to a suitability standard, meaning they agree to act in a way that does not harm their clients. Clearly, there is a big difference between the fiduciary and suitability responsibilities.

Why is there so much confusion revolving around these two ways of representing clients? It's on purpose. "Fee-based" is a term heavily touted by brokerage, insurance, and annuity industries. They do everything they can to narrow the perceived gap between themselves and fee-only advisors. After all, why would a consumer work with an advisor who is financially motivated to represent the best interests of their firm rather than that of their clients? Unfortunately, their "blur-the-line" campaign has worked. The vast majority of investors are not even aware that there is a difference between fee-only and fee-based. In fact, most consumers are not even familiar with the term "fee-only," because only .25% of financial advisors never accept product commissions.

Next time your seeking financial advice, don't be tricked. Remember there is a better way to obtain representation for your best interests.

More Positive News

Thursday morning reports showed jobless claims fell last week and retail sales ticked higher in May.

Initial claims for unemployment benefits fell by 24,000 last week to 601,000, a much sharper drop than expected. This comes after the May jobs report showed an unexpectedly small number of job losses.

Meanwhile, retail sales rose 0.5 percent in May, the first gain in three months, boosted by rising gasoline prices. April sales were revised to a 0.2-percent drop, half the 0.4-percent decline initially reported.

Lastly, business inventories shrunk by 1.1 percent in April, the eighth straight month that businesses have pared back their inventories.

An Eye On Oil

Oil futures jumped 2.8% on Tuesday, to $70.01 a barrel. That is the highest settlement price we have seen since November 4th. The latest jump came after the American Petroleum Institute reported a bigger than expected drop in stockpiles last week.

A falling dollar contributed to oil's rise and pushed raw materials prices higher across the board. The U.S. Dollar Index tumbled 1.2% while the Dow Jones-UBS Commodity Index rose 2%. Most commodities are traded in dollar terms so a weaker U.S. currency means it takes more dollars to buy the commodity.

Most Americans Not Prepared for Retirement

The recession has not prompted many people to change their behavior and start saving more for retirement, according to a new survey by Charles Schwab.

The quarterly survey found that many Americans are neither financially nor emotionally ready for retirement, even as they approach their retirement years. Almost four in 10 Americans are not currently saving for retirement and, despite market losses, six in 10 Americans have not adjusted their thinking about what age they will retire.

Survey respondents estimate they will need just over $1.2 million to comfortably retire, yet those currently saving for retirement have put away an average of $194,000. Despite this awareness, 41 percent of Americans feel positively about their retirement preparedness and another 22 percent feel indifferent.

A deeper look at those closest to retirement (ages 55-63) shows a gap between planning and reality. Fifty-one percent of 55-63 year olds surveyed have saved less than $500,000, though they most commonly believe they will need $2,000,000 to retire comfortably. To help bridge the $1,500,000 gap, 52 percent of this group are thinking they will retire later than planned, while 47 percent report they have not changed their thinking about retirement.

Among respondents aged 18-34 years old, 35 percent feel “indifferent” when it comes to their retirement preparedness, with 11 percent citing “fear” and another 9 percent responding with “anxiety.” Almost three in four assert that, despite the economy, they haven’t changed their thinking about when they will retire. Additionally, nearly six in 10 of those 18-34 years old confess they are not currently saving for retirement. Among savers, an average of just $23,000 has been set aside for retirement purposes.

To give your retirement contributions a shot in the arm and develop an appropriate diversification strategy, speak to a fee only, independent financial advisor who has a fiduciary obligation to act in their clients best interests.

What Influences the Price of Oil?

The decline in crude oil prices that began in mid-2008 was historic – plunging over $90 per barrel in just eight months. Over the past four months, however, crude oil prices have spiked up nearly $30 per barrel. Today’s chart provides some perspective on the historic decline and recent spike with a long-term view of inflation-adjusted West Texas Intermediate Crude.

Today's chart illustrates that most oil price spikes were a result of Middle East crises and often preceded or coincided with a US recession. It is also interesting to note that the recent spike in oil prices has brought the price of oil back to a relatively high level – a level that was surpassed only during the major price spikes of 1979-1982 and 2005-2008.

Health Savings Accounts

Six years after health savings accounts were introduced, only 59% of the population has heard of them, only half of these people actually understand them, and only 14% of the overall population own them, Guardian Life Insurance found in its Spotlight on Consumer-Driven Health Plans Survey.

Fifty-two percent did not know that contributions to HSAs are tax deductible, and 55% did not know that withdrawals used for qualified medical expenses are also not subject to taxes. In addition, 60% did not know that they can take the HSA with them when they switch jobs. For their part, employers also mistakenly think that HSAs are complex. Many also do not contribute to employees’ HSAs, which Guardian found would make the plans more attractive to 61% of employees.

Advisor Sentiment Turns Positive

Advisor confidence in the economy and the stock market improved in May, to a reading of 100.48—up nearly seven points from 93.59 in April, according to the Rydex/SGI AdvisorBenchmarking Index. May’s reading is the highest level reached since October 2007.

Stronger advisor confidence stemmed from increased consumer optimism and recent signs of economic revival, according to Rydex. The Conference Board Consumer Confidence Index also improved considerably, and was 39.2 in April, up from 26 in March.

What does this all mean? Sure, advisor and consumer confidence is a positive element of a market surge. However, advisor confidence is now at a level not seen since October, 2007 - right when the recent market collapse began...

Diversification, Rebalancing, and the Pain to Gain Ratio - Bringing it all Together

In previous posts, I've stressed the importance of diversification and finding an asset allocation that reflects an investor's risk tolerance. The following chart illustrates the rates of return of the major assets categories, both during the market decline that began in October of 2007 and during the market rebound that began on March 9th.


Several points here. First, although we have all enjoyed the recent rally in the stock market, don't trick yourself into believing the market will quickly recoup your losses. Recall the pain-to-gain ratio (previous post) which illustrated how a 50% loss would require a 100% gain in order to break even. As enjoyable as the past three months have been, most asset categories aren't even a third of the way to recovering the losses suffered during the 15 month downturn.

Second, an appropriate asset allocation is crucial. An investor with a significant portion of a portfolio invested in bonds clearly came out ahead of the market during the down time, and now has much less to go in order to break even. For instance, a portfolio of 50% stocks and 50% bonds was likely only down 20% during the market pullback, and would only need a positive return of 25% to break even. This investor is close to getting back to even already.

Lastly, as many financial professionals predicted, many of the asset categories that were hit the hardest during the recession have come back the strongest. Mid cap, small cap, and international stocks, all big losers during the market decline, are the biggest winners since the turnaround. Consequently, investors who were committed to their investment approach utilizing a diversification and rebalancing strategy have been rewarded. Individuals who didn't stick to their strategy sold at or near the bottom, and have missed the bounce.