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Posts Tagged ‘Floating-Rate Notes’

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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For individuals in retirement living on a fixed income, it can devastate one’s savings and lifestyle.

As a bond or CD-holder, the purchasing power of regular interest income gets hit.  As a stock investor, stock prices can suffer as profit margins and earnings of your equity holdings are hurt by the higher costs for inputs like energy, precious metals and labor.

Right now, Wall Street is in a good mood.  For the quarter just ended, the Dow has gained about 14%, the S&P increased 14.5% and the NASDAQ was up 15%.  In fact the last time the Dow saw such a large quarterly surge was back in the fourth quarter of 1998 when it rose more than 17% as the dot-com bubble was forming.

This quarter’s rally continued a trajectory that began in mid-March 2009.  It has been primarily propelled by glimmers of light at the end of the tunnel.  A variety of positive statements from Federal Reserve Chairman Ben Bernanke contributed to a more optimistic view.  Residential real estate sales continued to come back mostly prompted by a first-time homebuyer tax credit.  Corporate earnings have been up.  The popular “cash for clunkers” program spurred auto sales and by some measures consumer spending increased marginally even without the impact from auto sales.

Despite the Wall Street rally, Main Street is still hurting: unemployment continues to rise, business and personal bankruptcies have increased, bank failures are at their highest level and the dollar continues to weaken fueling fears of inflation down the road.

Signs of future higher inflation are on the radar screen:  All the government economic stimulus here and abroad coupled with mounting public debt; the Fed’s projected end of a program in March 2010 that will likely lead to higher mortgage rates; a Fed interest rate policy which has no place to go but up and rumblings that foreign governments and investors may not want to continue at their current pace of supporting our debt habit. 

So how do you position yourself to profit whichever way the tide turns?

Now, more than ever, it is important to have a risk-controlled approach to investing.  This is centered on an age-based allocation that includes exposure to multiple assets.

This is why we will continue to manage portfolios with an allocation to bonds and fixed income but there are ways to protect from the impact of inflation and still allow for growth.

1.)    Include dividend-paying equities:  Using either mutual funds or ETFs that have a focus on dividend-paying stocks will help boost income as well as return.   Stocks that pay dividends have averaged near a 10% annual return compared to a total return less than half of that for stocks that rely solely on capital appreciation.  Better yet, consider stock mutual funds or ETFs that focus on stocks that have a record of rising dividends.

2.)    Stay short:  By owning bonds, ETFs or bond mutual funds that have a shorter average maturity, you reduce the risk of being locked into less valuable bonds when higher inflation pushes future interest rates up.

3.)    Hedge your bets with inflation-linked bonds: Fixed-rate bonds offer no protection against inflation. A bond that has changes linked to an inflation index (like the Consumer Price Index) like TIPS issued by the US-government or ETFs that own TIPS (like iShares TIPS Bond ETF – symbol TIP) offer an opportunity for a bond investor to get periodically compensated for higher inflation.

4.)    Float your boat with Floating-Rate Notes: These medium-term notes are issued by corporations and reset their interest rates every three or six months.  So if inflation heats up, the interest rate offered will likely increase.  Yields in general are higher than those offered by government bonds typically because of the higher credit risk of the issuer.

5.)    Add Junk to the Trunk: Hi-yield bonds are issued by companies that have suffered down-grades – sort of like homeowners with dinged credit getting a mortgage.  Yields are set higher than most other bonds because of the higher risk.  Yet, as inflation heats up with a growing economy, the prospects of firms that issue junk improve and the perceived risk of default may drop. So as the yield difference narrows between these “junk” bonds and Treasuries, these bonds offer a “pop” to investors.

6.)    Own Gold and Other Commodities:  Whether as a store of value or hedge against inflation, precious metals have a long history with investors seeking protection from inflation.  It’s usually best to focus on owning the physical gold or an ETF that is tied directly to the physical gold. Tax treatment of precious metals is higher because of its status as a “collectible” but this is a minor price to pay for some inflation protection.  And because the demand for commodities in general increases with an expanding economy or a weakening dollar (in the specific case with oil), owning funds which hold these commodities will help hedge against the inflationary impact of an expanding economy.

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