Karl W. Blovet & Associates

Market conditions are compelling investors to reassess their investment strategies. Investors again value investments that emphasize capital preservation. Fortunately, there are viable alternatives when seeking safety. Because safety means lower returns, you must maintain a strict policy of minimizing investment costs. Investments with a higher degree of safety can be found in bonds and annuities. The following discussion is not intended to recommend one investment over another, but to highlight the necessity to fully analyze any investment from an integrated tax, risk, return, and cost perspective.

Debt-Based Products

Bonds can offer a higher degree of principal protection than equity securities, but they are not as readily tradable. Due to liquidity factors, obtaining reasonable pricing requires considerable effort on an investor’s part. However, this effort is well rewarded because a bond’s fixed return component means that higher fees have a significant negative impact on returns. Options range from actively “pricing out” a bond issue, buying an initial bond issuance, or purchasing a low-cost bond fund. Bonds typically have a lower return potential than equities due to enhanced safety, although one can purchase junk bonds for higher returns, but with greater risk.

Treasury Securities

Treasury securities are backed by the full faith and credit of the U.S. government. They are considered the safest investment available. The major drawback is that yields on these securities have fallen to historic lows. The prior budget surplus has reduced the offering of these securities, but they still can be purchased directly from the U.S. government (www.treasurydirect.gov/). Directly purchasing from the government is a distinct advantage in that you can obtain a market-based price without having to negotiate with a third party on pricing and/or to incur trading commissions. The Treasury now only issues notes that mature in 10 years or less (the 30-year bond is no longer issued). Treasury interest is free from state income taxation.

Treasury Inflation Protected Securities

Treasury inflation protected securities (TIPS) are a relatively new investment option whereby an investor is protected against inflation. These bonds pay a lower fixed rate, but the principal value is adjusted upward to offset inflation (based on the Consumer Price Index). In the current low interest rate environment, this feature is highly appealing if interest rates start to increase. A major drawback is that the principal adjustment is taxable as credited, but not paid until maturity. The use of a tax-deferred or tax-free account (such as a Roth IRA) would make this tax problem irrelevant.

Agency Securities

Agency securities are debt instruments issued by a governmental entity that is part of the U.S. government. Because they are typically not backed by the full faith and credit of the U.S. government (only indirectly backed), they generally pay a slightly higher rate of interest than Treasury securities.

Ginnie Maes

Ginnie Maes securities represent pools of mortgages that are backed by the full faith and credit of the U.S. government. You can purchase a Ginnie Mae directly ($25,000 minimum), but the use of a low-cost Ginnie Mae mutual fund is probably a better approach. Funds can offer greater diversification in underlying pools and professional management. The major risk is that principal is typically paid back when interest rates fall, and therefore, Ginnie Maes would tend to lose value.

Municipal Bonds

Municipal bonds have the tax advantage that their interest payments are free from the regular federal tax. However, the alternative minimum tax (AMT) can be applicable if they are “private activity bonds issued after August 7, 1986.” The AMT is affecting more taxpayers with the imposed 2001 scheduled tax rate decreases. Private activity bonds tend to offer higher yields due to this distinct tax disadvantage. Another disadvantage is that state income taxation of municipal bond interest occurs if it is not issued from the state in which the taxpayer resides. The interplay of the federal regular income tax, alternative minimum tax and state income taxation necessitates a high degree of tax planning to maximize after-tax returns.

Corporate Bonds

Corporate bonds generally offer the highest yields but without the safety level of government-backed bonds. Additionally, they are taxable on the federal and state levels. You can obtain corporate bond pricing data from the National Association of Securities Dealers, Inc. (NASD) for approximately “500 investment-grade corporate bonds” at www.nasdbondinfo.com/asp/home.asp. One alternative is to invest in preferred and convertible preferred shares instead of corporate bonds.

Other Debt-Based Products

Other debt-based products are bank-based certificates of deposits (CDs), saving accounts, money market accounts and savings bonds. Savings bonds (HH, EE or inflation indexed) in certain circumstances are ideal investment vehicles. For the highest yielding money market funds and bank accounts, you can find yields at www.imoneynet.com and www.bankrate.com. However, a higher yield, as always, can indicate additional risks. A bank investment has the advantage of being federally insured up to $100,000. Money market funds are not insured, and losses, while infrequent, do occur.

Annuities

Annuities have income tax advantages, but they typically are loaded with excessive fees. A $50,000 annuity can generate brokerage fees of up to $4,000, which virtually negates the tax advantage. Proceeds in excess of the investment are taxable as ordinary income upon withdrawal. Also, amounts withdrawn before age 59 ½ are subject to a 10-percent early withdrawal penalty. Additional complicating factors are surrender fees and annual operating fees. It is essential that you seek independent assessment prior to purchase; we can assist you in this area.

Fixed Annuities

Fixed annuities offer a high degree of payout certainty (as long as the underlying company is financially viable). However, they are typically expensive to purchase, resulting in lower overall return potential. Web sites such as www.immediateannuity.com and www.brkdirect.com can be used to obtain competing rates of return. Caution is necessary in verifying an insurance company’s financial credit worthiness. Moody’s reported that American International Group, MetLife, Aegon and Prudential Financial each had over $1 billion in credit “exposure” from bond investments in Worldcom, Enron, Qwest, Williams, TYCO, Dynegy, Global Crossing, Adelphia Communications, Kmart and Xerox. In total, life insurers “held about $23 billion” in these companies, most of which were considered “financially stable” until recent events. State guaranty plans offer only limited protection.

Variable Annuities

Variable annuities are essentially mutual funds with tax deferral. They offer a limited insurance element to qualify under the tax law. There are low expense annuity options available, but “many variable annuities carry substantial fees, as high as 4% annually.”

Dividend Paying Stocks

Dividend paying stocks are now looking much more attractive. Companies, such as Disney, even converted from the standard quarterly distribution to an annual distribution. Dividend yields had dropped to one percent, but are now above two percent. Although, there is no guarantee that any company will pay dividends.

Real Estate Investment Trusts

Real estate investment trusts (REITs) speculate in real estate properties. They typically have a high dividend yield because, in order to qualify for favorable tax treatment, they must distribute 90 percent of their income back to the shareholders. REITs have had a remarkable performance in the current market conditions, but as history shows, the best performing asset classes do not maintain their status indefinitely. REITs can be equity or mortgage based or a combination of both. Mortgage-based REITs subject investors to additional credit risks and were often considered part of the prior problem with this asset class. REITS can be issued on a variety of rental properties.

Guarantee Funds

Guarantee funds are sold on their ability to guarantee investors at least the return of their initial investment (principal). The funds have high fee structures, are limited in the assets in which they can invest and typically offer a principal guarantee only after several years. As the market falls, they are forced to sell more of their equity holdings and place the proceeds into bond-based products. In essence, you obtain an expensive balanced fund (containing both debt and equity) that will move more towards bond-based funds when the markets fall. As the funds invest in more bonds, their yearly tax effect will increase, and therefore, they are not “tax friendly.” Sales charges over five percent are not uncommon, and these funds have an average annual expense ratio of 1.5 percent.

Tax-Integrated Investing

Besides offering an independent assessment of investment alternatives, we can assure that the tax impact of different investments is fully and correctly integrated in financial planning. Investors and/or their advisors all too often ignore the following:

1. Tax-exempt interest considerations

  • How does the AMT affect the situation?
  • Is interest on municipal bonds taxed at the state level?

2. Treasury securities

  • Ability to defer income taxation to the next tax year
  • Advantageous avoidance of state income taxation
  • Ability to match maturity of a Treasury security with the tax obligation

3. Use of tax-deferred accounts to invest in unfriendly tax investments (interest paying, TIPS, etc.)

4. Utilization of the new capital gains rates of 18 percent and 8 percent

5. Proper use of tax losses

6. Consideration of transfer taxes and stepped-up basis issues

Conclusion

The current market downturn has forced investors to reassess their financial plans. Emphasis needs to be placed on investments with better return characteristics, as opposed to recommending a particular investment product. We believe that clients require unbiased information, not a sales pitch. Due to the fact that most brokers work on a commission basis, a direct conflict of interest exists between brokers and their clients. We can ensure that you are fully aware of the tax, risk, return, and cost factors of investing.