2002 Lane Reports

Are You Looking For Lower Risk Than The Equity Markets, But Higher Return Than CDs, Treasuries, and Money Markets?

Tuesday, October 1, 2002

Over the past two years, as investor sentiment has soured and stock markets have declined, many risk-averse individuals have shifted many of their assets into safer refuges such as CDs, Treasuries and money market accounts. However, investors face a dilemma - - lowering risk means giving up the potential for future appreciation. Fortunately, there are alternatives, which can provide good returns while minimizing risk.

Before we begin this journey, we need to understand the risk/return tradeoff and how taxes and inflation affect your investment. The risk/return tradeoff can easily be called the “iron stomach” test - - deciding what amount of risk can you take while still being able to sleep at night. This is something everyone needs to assess. The risk/return tradeoff is the balance between the desires for the highest return with the lowest risk, sometimes called the “Efficient Frontier.” Historically, investors who chose maximum safety felt they had to give up investment appreciation, but there are investment alternatives which can provide a comfortable balance between risk and return.

Let's address taxes and inflation . . . the ugly side of investing. Inflation erodes the purchasing power of money because of the persistent increase in the cost of goods and services you buy. On average, inflation increases approximately 2-3% annually. In the 1980's inflation reached double digits. As for taxes, depending on your tax bracket, your net return from taxable investments may be even less than inflation. For instance, an investment of $1000 in a money market or CD instrument currently paying annual rates of 1.5% and 3.25%, respectively, will earn $15 on the money market and $32.50 on the CD. If we factor in inflation of 2% and taxes in the 28% bracket, you've actually earned only $10.50 on the money market and $22.75 on the CD, approximately 1% and 2.3%, respectively, on your investment.

We are at a crossroads. How do we get returns that will beat inflation and taxes but risk small enough to allow us to sleep at night? Although a diversified portfolio of stocks and bonds is your best long-term bet, here are some fixed income vehicles to consider:

Preferred Stocks

Preferred stocks are hybrid securities that combine the characteristics of common stocks and bonds. Most preferreds are traded on the New York Stock Exchange; they represent about $60 billion of the market value of the NYSE-listed stocks. Preferred stockholders enjoy a fixed dividend stream that typically yields more than other fixed income securities. Preferred stockholders have the advantage of receiving dividends before common stockholders. Additionally, preferred stocks which have a conversion option may be exchanged for a fixed number of common stock shares. While convertible shares may appreciate in value, they typically experience less volatile price swings than common stocks, so there is less risk.

Preferred stocks do not have a maturity date like other fixed income securities; they usually have a call feature. A call allows the issuer to buy back your shares when interest rates are dropping, so that the issuing company can relieve itself of the burden of paying out higher dividends by issuing lower-paying shares. Nevertheless, investment-grade preferred stocks are currently yielding 6-7%, which is ideal for investors who want higher returns with less risk.

Corporate Bonds

Corporate bonds are debt instruments issued by corporations. They have stated coupon rates, are rated on their creditworthiness, and have a specified maturity. Corporate bonds have historically attracted income seekers, but should now also be considered by those looking for attractive risk-adjusted returns, because in today's low growth, low inflation environment, income is playing an increasingly important role in producing investment returns. As a result, current bond investors should take the time to consider reinvesting any income generated back into their corporate bonds to boost total return potential, which can now be achieved without having to increase exposure to the volatile stock markets.

Currently, a 10-year, AA-rated corporate bond is yielding 5.14%, as compared to a 10-year Treasury bond that is yielding 3.66%. This difference represents almost a 2% spread between these two securities. Historically, corporate bonds have yielded approximately ˝% higher than Treasuries, but Treasury yields are at an all time low due to investors selling stocks and stock mutual funds because of fear about war, equity market weakness, and the discontinuance of the 30-year Treasury bond.

Corporate bonds are not without default risk and financial risk. That's why there are companies that specialize in evaluating corporations and other bond issuers to determine their fiscal strength. Moody's Investors Services, Fitch IBCA, and Standard & Poor's Rating Services all specialize in assigning ratings to bonds and preferred stocks that determine the ability of their issuers to repay these obligations.

Municipal Bonds

Municipal bonds are debt obligations of a state or local government entity. The funds may support general governmental needs or special projects, such as building schools, hospitals, highways, and many other projects for the public good. By purchasing municipal bonds, just like corporate bonds, you will earn a specified amount of interest until the bond's maturity date, when you will receive the principal amount of your investment back.

The most enticing aspects of municipal bonds are that they are federally tax-exempt and may also be state tax-exempt, depending upon the state in which you reside. Municipals bonds are suitable for investors in higher tax brackets, seeking investments that will provide an attractive after-tax yield. One of the best ways to understand the tax-exempt advantage of a municipal security is to compare it to a taxable investment offered by an issuer which is just as creditworthy. For example, assume you are in the 38.6% federal tax bracket and have invested $50,000 in two investments - - a taxable investment yielding 7.5% and a tax-exempt bond yielding 5%. Which investment is more advantageous?

  5% tax-exempt bond 7.5% taxable investment
Investment $50,000 $50,000
Interest $2,500 $3,750
Federal income tax at 38.6% 0 $1,448
Net return $2500 $2,302
Yield on investment after taxes 5% 4.6%

As you can see, the municipal bond would provide the best yield after taxes are taken into account.

To be fair, a word of caution about municipal bonds:

-Interest earned on municipal bonds are federally tax-exempt, but may be taxed at capital gains rates if sold at a profit.

-Although interest is federally tax-exempt, it still needs to be reported on your tax return.

-Alternative Minimum Tax (AMT) may apply to interest earned on municipal bonds.

Municipal Bonds are an effective tool for tax-efficient investing.

All securities go in an out of favor, and a diversified portfolio of stocks and bonds will be most beneficial in the long run. However, preferred stocks, corporate bonds and municipal bonds add tremendous value in providing good returns while lowering risk.

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The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.

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