Financial Planning Archives November 2008

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November 25, 2008

Making Sense of Bond Yields

Volatility is a very important discussion to have with clients before they invest. In many cases clients will choose bonds over stocks because of a perceived lower level of volatility found there. Historically, that’s a fair assumption--rarely if ever in the past 20 years has a portfolio of municipal bonds represented a similar level of risk to stocks. People are also taught to buy bonds for the yield and to not pay close attention to daily fluctuations in price. Well, like a lot of other things, 2008 has changed the rules. Bond volatility combined with mark-to-market accounting rules has helped crush the daily trading prices of many bonds. It has also caused a phenomenon of highly rated bonds offering competitive yields. So, does this present an opportunity for investors? Here are a few things to know:

First, many industry experts and financial planners whom I’ve spoken with believe some of the best bond market opportunities are in the municipal markets. Municipal bonds generally pay a lower rate of interest than corporate bonds in exchange for better safety. Unlike corporate issues which rely on consumer spending and other variables, municipals generate income through more reliable tax revenues, tolls and other consistent sources of revenue. An added benefit is that many municipal bond issues are exempt from federal and/or state income taxes—although not all, so you’ll want to contact your financial and/or tax professional for confirmation.

The yield surge phenomenon is directly correlated to the drop in bond prices. Among the major factors which have caused these steep price drops are the heavy selling volume on behalf of hedge funds and other institutional investors who need to raise cash to meet liquidations requests. The bond market selloff was further exacerbated after investors lost faith in rating agencies which made determinations about the riskiness of each issue. Once it came to light that rating agencies were more focused on generating profits than giving honest assessments of bond risks, the liquidation requests continued to roll on. The sub-prime mortgage mess made the rating agencies look somewhat negligent and many investors have decided to sit on the sidelines during periods of uncertainty.

The unfortunate part of the municipal bond story is that the current recession and lack of consumer confidence only makes the actual problems for the municipalities worse. The deteriorating financial sector directly equates to lower tax revenues for New York City, where I live. The fewer people traveling to and from the city, the less revenue we collect as a result. All of these factors serve to legitimize the lower pricing of bonds, rather than encourage their rebound. Because we shouldn’t just trust rating agencies to decide for us what the real risks of a bond investment are, investors need to proactively look into the credit risk of a bond before buying it.

One should also look at whether or not a bond investment is leveraged. Leverage has been poison to the market over the past year or so. It may be prudent to avoid investments which utilize leverage to ‘juice up’ the returns.

What we do know is that very few (less than 1%) of municipal bonds have actually defaulted, at least here in New York City. Default risk is truly the largest concern a bond investor should have if they plan to buy a bond and hold it to maturity. So, we know that fear has pervaded the market and at this point is somewhat responsible for continuously lower re-pricing. Over the long-run, if and when we do bounce out of this recession, municipals may prove to be an excellent long-term investment.

Question, comments? Feel free to e-mail me.

Russell Bailyn
--
Wealth Manager
Premier Financial Advisors, Inc
14 E 60th Street, #402
New York, NY 10022
P: 212-752-4343 *31
F: 212-752-7673
rbailyn@premieradvisors.net

Corporate bonds are subject to interest rate risk. Investors should be aware that bond values may decline, if interest rates rise. Municipal bonds, corporate bonds, US Treasury Securities, Government Agency Bonds, and CDs will fluctuate in value and if sold prior to maturity may be worth more or less than their original cost.

Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.

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Has Hank Paulson Been A Good Treasury Secretary?

Now that Hank Paulson is a lame duck, and we’ve seen the majority of his contributions as Treasury Secretary, we can begin to assess whether he has been handling the unfolding economic downturn effectively, or as some might suggest, made it worse. As is usually the case with economic policy, we can rarely determine with certainty what was a ‘correct move’ for several months if not years afterwards. My opinion is that Paulson has done an adequate job so far in terms of avoiding a deeper recession or depression, but has made some questionable moves and has been less than sensitive to the needs of Wall Street.

First things first: many would agree this recession was brought on by a housing bubble which has left millions of Americans in foreclosure who were either encouraged in some way to become a homeowner (when they weren’t quite ready) or straight up duped by a bank or other broker into taking on a confusing mortgage product which would presumably be beneficial in the long-run. So, it would seem to me that preventing future foreclosures would be an equally important priority, especially from a moral perspective, than protecting the banks which ultimately take on the mortgage losses.

Taking the ‘moral high rode’ hasn’t really happened, or at least hasn’t been pushed strongly enough. Some people in my office weren’t even aware of the ‘Hope Now Alliance’ which was established over a year ago by Bush, Paulson and their other advisors to help financially troubled homeowners avoid foreclosure. As far as I know, the quantity of foreclosures has increased dramatically in 2008, certainly outnumbering the people aided by this program. And when the details of the TARP (Troubled Asset Relief Fund) otherwise known as the ‘$700B Bailout’ were revealed, among the major criticisms was the focus on helping banks rather than troubled homeowners.

I also believe Paulson could have been a bit more sensitive to the precipitous drop in the markets, the worst of which we saw last week when all the major market indexes touched intraday levels not seen since the 90’s. Granted, it is not the Treasury Secretary’s job, nor is it the Fed’s job to intervene with the daily movement of the stock market. If they did, and it helped to push markets to unnaturally high levels, it would lead to more economic problems rather than the stated goals of moderating inflation and sustaining reasonable levels of economic growth. Even so, there is more Paulson could be doing to moderate these unprecedented levels of volatility. This recession is the worst we’ve seen since the Great Depression; many financial institutions have either collapsed, been diluted by the government, or sought an enormous influx of capital. Investors are scared about where and when the next shoe will fall. As the stock and bond markets deteriorate, the recession gets worse. As people’s homes and retirement accounts decline in value, they spend less as a cautionary measure, often exacerbating the existing problems and forcing the government into enormous spending patterns.

One opportunity Paulson had to moderate these declines was to suspend the mark-to-market accounting rules which have nearly crippled the balance sheets of financial firms along with the bond market over the past few months. Market-to-market accounting essentially forces companies to value the securities they hold (such as the mortgage-backed stuff) at their fair market value—essentially the current market price. Because much of the collateralized debt market has nearly disappeared, the market prices are often 50-80% lower than they were a year ago. Some organizations such as the The American Bankers Association have argued that mark to market accounting doesn’t work in extremely volatile and turbulent markets. It’s designed more for markets in which the securities have liquidity. And because of bank requirements regarding capital levels, write-downs due to mark-to-market accounting force banks to raise more money, raising eyebrows and snowballing the problem further. It should be noted that scaling back these accounting rules still remains on the table for the SEC, despite Paulson’s support against doing so.

Others would argue Paulson handled a certain investment bank failure very poorly. I can’t say the name of the bankrupt bank for compliance reasons but it should be fairly obvious considering it’s the only one Paulson let fall. The result of this failure was a crisis in the commercial paper and money markets. The ‘systemic risk’ of letting such a large and diverse global bank fail was sending shockwaves through every institution doing business with the bank. That is precisely what happened and the stock markets got much worse in September and throughout November. If Paulson is going to become the bailout guy, don’t discriminate—save each business which has a reasonable chance at surviving after this recession pans out.

Finally, and most recently, Paulson has been very ambiguous when it comes to details for spending the TARP funds. If you’re going to dump a mega-bailout on taxpayers, the least you can do is provide the same transparency for taxpayers which you’re promising investors. Paulson has bent the rules such that public and private institutions—basically anybody who can cough up a reason why their business failure may pose a systemic risk to functional markets, can ask for a piece of the pie. The updates on the program have been unclear and the distribution of funds has already been questionable.

I’ll give Hank Paulson one thing: John Snow and Paul O’Neill had it much easier than Paulson. Even Larry Summers, who was Treasury Secretary during the dot com bubble, had much less to deal with than a global financial meltdown. Paulson may have been dealt the worst cards in memory and the fact that we’re not in a deeper recession already is a credit to him.

As always, questions and comments are welcomed.

Russell Bailyn
--
Wealth Manager
Premier Financial Advisors, Inc
14 E 60th Street, #402
New York, NY 10022
P: 212-752-4343 *31
F: 212-752-7673
rbailyn@premieradvisors.net

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November 11, 2008

Obama and Taxes: What We Can Expect

Whether or not you liked George Bush, his budgets over the past four years have consistently called for more tax cuts and extensions for expiring tax provisions which would otherwise hike taxes. Last year, Bush extended the lower marginal tax rates on ordinary income and the preferential rates on capital gains and dividend income. The goal of these tax cuts was to raise individual incomes, add jobs to the economy and lower unemployment. Well, no luck so far on reaching those goals. On Friday we learned of 240,000 more job losses last month and a national unemployment rate of 6.5%. So now the question becomes, what can we expect from President elect Obama? Lots of people on Wall Street are scared of a scenario in which Obama raises taxes shortly after getting into office presumably in the middle of a recession. Herbert Hoover did the same thing in the early 1930’s. It led to the Great Depression. Are we in a similar predicament? What can we expect over the next four years from Barack Obama in terms of taxes?

First, it should be noted that in light of the recent economic downturn, it’s possible that Obama’s tax plans will get deferred for a year or two. Because his overall plans are to raise taxes on higher-income earners and lower taxes for the middle and lower-middle classes, his tax plans aren’t viewed as a ‘stimulus.’ And because of the recent stock market declines, Obama and his advisors might pay more attention to monetary policy and new legislation to stimulate growth over his longer-term economic agenda. Now, if you asked him, he would tell you that the large majority of workers in this country will pay lower taxes under his administration, not more. His tax increases would hit hardest those with earnings over $200,000, and those businesses which have pass-through taxation and therefore would fall into this category as well. Because over 95% of Americans would actually have their taxes reduced under his plan, he views it as a ‘net tax cut’ to Americans. The effects are debatable but that fact I believe to be true.

Obama proposes raising the tax rate (married filing jointly) to 36% from 33% for each dollar of earned income between $200,300-$357,700. For each dollar over $357,700 he proposes raising the rate to 39.6% from 36%. He also wants to increase the capital gains and dividend tax from its current 15% rate to 20%. Estimates from Deloitte & Touche are that a family of four with $500,000 in income from wages, interest and capital gains would pay approximately $3,100 more in taxes under the Obama plan. Unmarried individuals and those filing separately would get hit with the tax hike at $164,550 rather than at $200,300.

The way in which middle and lower-middle income people would see a tax cut is largely through his Making Work Pay Credit (MWPC) and other tax credits. The MWPC would essentially create a tax credit equal to 6.2% of the first $8,100 of annual earnings for workers making less than $75,000 per year. The credit, which amounts to roughly $500, would basically refund the employee’s portion of Social Security tax. Obama also proposes replacing the Hope Credit (max $1,800) with the American Opportunity Tax Credit (max $4,000). Like the Hope Credit, it wouldn’t apply to all 4 years of college and would have income restrictions as well. The earned income tax credit, which generally helps the lowest earnings individuals in the US, would be expanded under the Obama plan.

Obama has recently proposed other potentially stimulating fiscal policy as well. For example, he mentioned letting people withdraw 15 percent of their IRA or 401k balances up to $10,000 without paying the 10% IRS early withdrawal penalty that generally applies to withdrawals before age 59 1/2. While clever in that it would almost certainly increase consumer spending, it’s really not a wise idea in my opinion. As it is, people don’t save enough money. Letting people crack their nest eggs is probably setting a bad standard. If our savings rate were 10% as a nation, maybe we would be more open minded about this kind of suggestion.

Time will tell how these various proposals ultimately come together. Obama has his plate full in terms of managing the broader economic environment, from the $750B bailout package to the looming failure of the American automobile industry, to aging workers and an outdated Social Security and Medicare system. At the very least, the next four years will be interesting.

Russell Bailyn
--
Wealth Manager
Premier Financial Advisors, Inc
14 E 60th Street, #402
New York, NY 10022
P: 212-752-4343 *31
F: 212-752-7673
rbailyn@premieradvisors.net

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