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Bonds are not the stodgy, boring things that most investors think of even though there’s no army of talking heads on financial news shows talking about them.

They are a huge market (about double the value of stocks as noted in my last post). They are an essential part of our economy.  Most companies cannot function without easy access to credit.  In fact, the shock and uncertainty that followed the collapse of some of the largest banks pretty much brought the economy to a standstill and contributed mightily to the Great Recession.

But that doesn’t mean that there isn’t money to be made in this asset class. Savvy investors of all stripes need to consider the value of bonds in a well-diversified portfolio.  And how you build that portfolio will help lower risks and costs and ultimately mean more money in an investor’s personal bottom line.

Whether someone is retired or not, bonds can provide income and potential capital appreciation (and depreciation if not hedged properly).

Bonds are a key part of an income-producing strategy (dividend-paying stocks are another asset class useful for this as well).

What is a Bond Ladder?

Essentially, a bond ladder describes a strategy to manage fixed-income investments by staggering the maturity dates of the various investments.

Some may be familiar with CD ladders: You select a series of bank certificates of deposit and stagger their maturity dates so that every six months, for example, a CD matures and you can reinvest the proceeds.

The advantage of this is that in a rising interest rate environment the investor is not locked out  of getting a higher rate on new money.

As with any fixed income investment, the disadvantage is that in a falling rate environment money that matures gets reinvested at a lower rate.

To minimize this impact professionals focus on the concept of “duration” which is a measure of how sensitive a bond (or any fixed income investment) is to changes in interest rates:  The lower the duration, the less sensitive and vice versa.

Mutual funds may publish an implied “duration” measure but it is not accurate because the fund, unlike the bonds themselves, is perpetual.

So to minimize risk to a fixed income portfolio, an investor (with the help of a competent financial professional) can create a custom portfolio.  And unlike a passive index fund, this custom portfolio can be built using bank CDs of staggering maturities for the near-term money coupled with a variety of bonds (corporate, US Government and municipal issues) with their own staggered maturity dates.

To mitigate the risks posed by higher interest rates caused by inflation or other political influences, the mix can also include “floating rate” bank notes. These are essentially bank loans to companies that adjust. Think of them like adjustable rate mortgages but to fund company operations  instead of real estate.

To add diversification to the mix, one can add closed-end funds that can be bought at a discount. These funds are professionally managed and offer an opportunity for price appreciation but at an expense ratio that is typically far lower than a conventional open-ended bond mutual fund.

By combining these elements, an investor may be able to lower the overall risk from interest rate movements, from default risk of individual components and from the impact of a “run on the bank” when others are selling (NAV risk).

And the overall cost of putting this together is cheaper than many mutual funds.  The cost to buy or trade an individual bond is typically included in the yield offered without any additional charge.  CDs do not have any added cost.  And for US Treasurys there may be a nominal fee (less than $3 per bond or example).

A knowledgeable financial professional can have access to hundreds of bond brokers.  By being independent and not beholden to any one broker’s inventory, an adviser can access offerings from multiple sources, find the best price and terms and lower an investor’s costs.

Depending on the total assets in the bond portfolio, the cost for professional management to monitor and make changes can typically run between 0.4% and 0.7% of the portfolio which is well under the cost of many mutual fund options.

For help putting your personal portfolio together, call Steve Stanganelli at Clear View at 978-388-0020 or 617-398-7494.

 

 

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There are many valid reasons to consider a 401k rollover.

Costs

While it may not seem like it, you are paying for your funds to stay with your old employer’s sponsored plan.  You just don’t see it.  Fees for employer plans are not very transparent.  While you may not see an actual bill, your employer is probably paying for the administration of the plan through hidden fees assessed on the balances held in it.

I have seen sponsored plans that had these back-end hidden fees and charged the participant a piece for each contribution.  A little here, a little there all adds up.  And the more it is, the less there is to compound for your retirement.

While there are few things that you can control in life and investing, fees are one of them.

In a rollover IRA, you’ll have more choices of platforms which may offer low loads and costs so you can keep more in your pocket.  So control what you can when you can for successful investing.

Choice and Access

While some employer plans may offer a variety of funds which may be top of the line, you’re still limited to the menu selected by your employer.  More often than not this is influenced by the broker associated with the plan.  And this can be influenced by the restrictions placed on the choices by the broker’s company or administrator because there may be an incentive to fill the menu with one fund family.

I’ve seen plans offered through national payroll companies that required more than 50% of the fund choices to be of one particular fund family.  Not every choice in a management company’s fund line up may be stellar so you’re limiting yourself by staying with the old plan.

When you rollover you’ll have a much larger universe to choose from.  (My company has access to more than 14,000 non-proprietary mutual funds with no loads or loads waived).  You’ll typically even have access to individual stocks, bonds, Unit Investment Trusts, Exchange Traded Funds and bank CDs.

Have you ever considered investing in something besides stocks, bonds or mutual funds? Maybe you might want to invest in real estate or buy judgments or invest in a business by being its lender or providing a friend with start-up capital.

Well, you can’t do that with a typical 401k plan.  But you can with a self-directed IRA.  And such an IRA can’t be done through the Big Box financial firms.  There are specialized bank and non-bank custodians who handle such transactions and work through independent financial planners to help their clients learn more about such options.

Risk Controls & Broader Choice of Investment Strategies

While you may have online access to your company-sponsored plan so you can make trades or switches of your funds periodically, there really are no risk controls that you can use given the limitations of the platform the 401k is using.

Let’s put it this way:  Investors make money when they don’t lose it.  At least that’s my working philosophy.  Having options and systems in place means that you stand a better chance of protecting your retirement nest egg.

It’s always easier to not lose money in the first place than it is to try to make up for lost ground.  Your money has to work harder to get back to breakeven much less get ahead for your retirement goals.

Consider this:  If you think that Treasurys or munis are in their own bond bubbles, what can you do to protect yourself through your 401k?  Probably, not much.  But in your own IRA you’ll be able to build a more all-weather portfolio that includes inflation hedges like convertible bonds, foreign dividend-paying stocks, master limited partnerships or even managed futures.  All come in mutual funds or ETFs which offer the advantages of diversification without the tax and cost structures of direct investment options.

Or maybe you want to minimize the impact of another downdraft in the market.  Using ETFs and trailing stop-loss orders you may help protect your gains.  Not an option in your old 401k.

So when you roll your account over, you’ll also have access to professional help, tools and direct management options tailored to your specific needs that you just can’t get within your old 401k.

Things to Consider:

iMonitor Portfolio Program

Money Tools DIY Program

For more information, please call Steve Stanganelli, CFP® at the Rollover Helpline at 978-388-0020 or 617-398-7494.

Check out the website and newsletter archive for more on this and similar topics:  www.ClearViewWealthAdvisors.com.

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It’s natural for investors who are still skittish after a decade-long roller coaster ride with the stock market and plummeting real estate values to be risk averse and seek out investment alternatives for protecting their nest eggs for retirement, college funding or simply their emergency cash.

And where there is demand, there will be supply.  So naturally, financial firms will design products geared toward satisfying this demand.

One such product that’s getting more attention recently are Market Linked Certificates of Deposit (CDs).

These are in essence a savings product designed to provide a minimum guaranteed interest rate plus the opportunity to increase the return by linking to the return of a specific market index or in some cases an index for inflation.

Such products are part of the larger class of “structured products” produced by investment banks that can come in many flavors and various strategies:  reverse-convertibles, principal-protected notes, Exchange Traded Notes.  They essentially are debt bundled with a derivative and marketed as a way to bet on stocks and interest rates as a way to manage certain risks. All offer in one package strategies using some sort of derivative and may offer a combination of principal protection, risk reduction and/or enhanced returns.

Recent surveys of more than 17 brokerage firms and more than 38 million investors show that most of these products are used by those with under $500,000 in investable assets.  For those with assets between $250,000 and $500,000, about 1.5% of their assets are placed in such products which is slightly higher than the 1.33% of assets for those with under $250,000 to invest.  (Investment News, 11/15/2010, page 52).

More than $70 billion of such products are held by investors with more than $42 billion bought in 2010 according to Bloomberg data.  And given continued uncertainty about the markets, the demand looks like it will not be abating any time soon especially as financial marketing organizations use investor fears as a selling point. Brokers and banks often receive higher fees and commissions for selling such products.

Keith Styrcula of the Structured Products Association said in a recent interview “these kinds of investments have become so attractive because people can no longer trust stock market indexes to go up.” He added that “there’s a lot of fear in the market right now, and a lot of investors don’t just want one-way exposure anymore.”  (Investment News, 11/15/2010, page 51).

But even though these products are marketed as a way to reduce risk they are not risk free.  There is no free lunch and this is no exception. Such products are subject to liquidity risk, market risk, credit risk and opportunity costs.

Market-Linked CDs are a form of principal-protected note offered by an investment bank.  These are not your Grandmother’s bank CDs.  First, such notes are offered as debt of the sponsoring institution so there is always the potential of credit risk.  Think of Lehman Brothers which was a large producer of such notes.  If the issuing firm fails, as Lehman did, the investment is at risk. While there is FDIC-protection on the principal, that may be small comfort when dealing with the time frame to get access to your money through a FDIC claim process.

They may involve a complex strategy which may be buried in the details of the offering’s prospectus.  For market-linked CDs, for instance, the issuer offers the downside protection by managing a portfolio of Treasury bonds (like zero coupon bonds to meet the projected maturity date of the CD).  The upside potential that is offered comes from investing in the bond yield through various strategies.

In such a low interest rate environment, these notes work only if provided sufficient time for the issuer to implement its strategies.  This is one reason that such CDs typically have long lock up periods that can be five years or more.

An issuer may guarantee a minimum interest amount but this is typically not FDIC-insured.  And this is really an obligation of the issuer so that’s where the credit risk comes into play. And you should note that the minimum guarantee usually only applies when the investment is held to maturity.  An investor will lose this guarantee by redeeming before the contract maturity date. And because of the nature of these products, there really is no secondary market around to allow someone else to buy you out early.

The upside potential is calculated based on the performance of the index chosen.  The CD investor does not own the index or the stocks in the index.  The issuer uses its money to invest and potentially reap the dividends issued as well as the appreciation.

What the issuer offers to the CD investor is a certain percentage of the upside gain of the index (called a participation rate) but limited by a ceiling (called a cap).  This calculation of the gain can be convoluted for an investor to understand. While it’s pretty simple to understand a typical CD (put $1000 in at an annual interest rate of 3% means you have $1,030 at end of the period), the same is not true for market linked CDs.

Your gain may be based on an average (so now the question is how are they calculating that average: monthly,  semi-annually, annually, term of the CD) or a Point-to-Point calculation. (Example: If the market index is 1000 when the account opened, went up to 2000 after one year but drops to 1050 by the maturity date, then the point-to-point is from 1000 to 1050 or 5% in this case).

In many ways these are similar to other structured products like market linked annuities (sometimes referred to as index annuities or equity-indexed annuities).

I addressed many of the same issues about calculating returns and possible risks in a post on the subject a while back.

Bottom Line:

Whether or not such products make sense for your personal portfolio really requires a good, long chat with a qualified financial professional. Like any other investment, the potential risks and opportunity costs need to be weighed against your personal goals, time frame, liquidity needs and the potential offered by other alternative options.

So if you are considering such products, just be aware of all the risks and look beyond the marketing brochure at the local bank.

Resources:

SEC Investor Education on Market-Linked CDs

MoneyLinkPro Blog Post on Market Index Annuities

Wikipedia Definition

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Like the mythical siren’s call, the pitch is enticing – a seemingly perfect investment.

Investors can buy into a contract offering a minimum return with the potential to capture the upside of increases in the stock market while avoiding portfolio value declines if – and when – the market goes down.

This blend of promises can be found in ‘equity-indexed annuities” or EIAs offered by insurance companies.

And these offerings have become popular given the steep declines in the stock market.  According to a report in the WSJ (9/02/09), sales of EIAs during the first half of 2009 rose 20% compared to a year ago to $15.2 billion.

As compelling as these products may sound, they are anything but simple.  There are many complicated moving parts to each EIA contract. So buyer beware!

Think of investing as finding the route to your destination (a goal) and matching that with the appropriate mode of transportation (or investment vehicle) to get you there.  You may be traveling from Boston to New York and can choose highways or back roads. You can choose hi-speed rail, a car, a bus, a bike or even a plane.  You can drive or fly yourself or hire someone else to drive. All will get you to where you want to go but it’s a question of what kind of comfort level you want on the ride, how much time you have to get there and at what cost – in fees or simply mental health.

For those who may not have the stomach for the gyrations of the stock market but are looking to be more venturesome, the EIA may be a suitable compromise. It’s sort of like someone hiring a driver for the trip but traveling on main roads while avoiding highways.

First, understand that an annuity is offered by an insurance company and backed by the credit-worthiness and deep pockets of the insurer.  There is no FDIC backing. This is not a bank product (although you may find them sold by brokers with desks in banks).

Next, understand that an index can be any benchmark for any asset class or market.  The most common benchmarks include the Dow Jones Industrial Average (DJIA), the S&P 500 and NASDAQ in the US.  Overseas, indexes include the NIKKEI in Japan for instance.

An equity-indexed annuity (EIA) ties the amount that will be credited to an investor’s account to the performance of a particular index. 

But don’t expect to receive a one-for-one increase in your account value based on the index’s increase.  Instead, these contracts include a “participation rate” that sets a percentage of the index gain that is used.

The index-based interest credit may be further limited by “caps” that set a maximum amount of gain.

For anyone who has ever had an Adjustable Rate Mortgage, the process is very similar to how loan rates are recalculated.

Calculating the interest credit is further complicated by the method of measuring the change in the index value.  For instance, the insurer can determine the index change based on the “Annual Reset” – the difference between the index value at the beginning and end of each contract annual anniversary date.  Or a “point-to-point” method may be chosen that compares the index value at the beginning date with some future date like the fifth anniversary. Or the insurer will use “index averaging” taking multiple index returns and averaging them.

By the way, the index value won’t include changes resulting from dividends. While total return on the S&P 500 averaged 9.5% between 1969 and 2008, more than one-third of the return was attributed to dividends.  So these EIA market participation formulas will be calculated on a lower base when dividends are not considered part of the index return.

Typically but not always, there is a minimum amount of interest that is credited. But be aware that this minimum interest credit may not apply to 100% of the contract value.  It may apply an interest rate of 3% to only 90% of the value.  It may apply 1.5% interest to 85% of the total value.  It all depends on the terms of the contract.

EIA contracts have dual values:  the one based on the index value, participation rate and cap; the other based on the minimum interest credit.  And if you get out of the contract before the full term, you may be forfeiting the index-based account value. The insurer would then pay out the amount based on the minimum guaranteed portion which may be lower than what you expected compared to the index formula.

And how many football fans would be happy if their favorite team was on the 1-yard line and the referees moved the goal post?  Well, most EIA contracts reserve the right to unilaterally change terms reducing the participation rate or using stiffer lower, caps for example.

And most contracts have very steep surrender charges that can start at 10% to 15% of the contract value in the first year and declining from there for up to 10 years.

And be aware of the financial incentives that are part of these contracts.  Some EIAs offer “bonuses” to investors – an extra 5% or 10% added to the initial deposit.  But there is no free lunch.  In exchange for such a bonus, the insurer will likely increase the surrender penalty.  So as much as the bonus is an incentive to open the contract, the penalty is an incentive to not move the money out.

Follow the money, too.  Many EIAs pay out commissions to brokers between 6% and 10% and sometimes more.  An investor should be aware that there may be an incentive by a salesperson to offer this as a catch-all solution whether or not it fits the investor’s particular situation. 

The advantages to an EIA include the opportunity to participate in the upside of a market index as an alternative to investing directly through mutual funds for instance.  When an investor opens up an annual statement, there may be less apparent volatility because the account balances aren’t fluctuating wildly.  So this may help a conservative investor dip a toe in the market and sleep better.  And like most annuity products, investors have free access to a portion of their money without surrender charge (usually 10%). And like any other insurance product, it provides a guaranteed death benefit.  Like other annuities, it offers an income stream that you cannot outlive.

The average return on such EIA contracts has been reported to be in the 5%-6% range.  Given the complexities of these contracts and the average returns, it may be a costly way to limit your market exposure but it may make sense for those looking for a principal-protected CD alternative for the cash portion of their portfolios as well as a source of income to supplement retirement.

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