Personal Investment Notes

The current value of an I-Bond, through Nov 1, 2009, is 0.00%. This is due to recent deflation.

The current value of an I-Bond, through April 30th, is 5.64%.

Read more about I-bonds on the TreasuryDirect I-bond website.

I saw a question: why did my bond fund lose money? In other words, why did the bond fund price drop?

A seemingly simple question.

I also wondered if the prospectus was read; if not, what was the person told? Oh, it won’t vary much…or at all…or not told a thing about volatility.

Bonds, when held to maturity, give you your money back plus interest. Bond funds, on the other hand, do not have a maturity date. They have to evaluate their portfolio every day, after market close, to see how much it is worth if it sold all its holdings. However, if you priced an individual bond every day as to what it would sell for, most likely it will vary from its issue price (normally $1,000 per bond)…but you will get your principal back at maturity date (or call date, if that occurs) as long as the company does not go bankrupt.

Depending on the risk of the bonds bought, the price of the bond fund can vary quite a bit (measured by standard deviation). Short-term bond funds will vary much less that high-yield junk bond funds.

In reality, holding a bond to maturity can cause losses…to inflation, taxes, and reinvestment. The purchasing power of $1000 thirty years ago was much more than it is today thus the interest the bond generates needs to make up for inflation and taxes just to stay even. Also, with an individual bond, unless you use it to generate monthly consumable income, the interest needs to be reinvested. The bond fund makes this easy but an individual must either save the money to buy another bond or reinvest it in something else such as a money market which probably pays less than the bond’s interest.

For bond funds, look at the standard deviation and compare it to other funds such as short-term bond funds (VFSTX, Vanguard short-term investment grade fund has a SD of about 3. FAGIX, Fidelity’s Capital & Income fund, a junk bond fund, has a SD of about 12.) and long-term or junk bond funds. You will get an idea of how much the price will vary.

Another source of information is the monthly prices of a fund. Scan them over to see how much they vary.

The standard deviation and monthly prices can be found on finance.yahoo.com under risk and historical prices.

Bottom line: the riskier the bond fund the higher the standard deviation and the more the prices vary. Choose your funds wisely.

If there needs to be a tie-breaker, then choose the fund with the lowest expense ratio. This is especially important in the bond world.

Passive income is the ultimate: regular income with little effort.

What is Passive Income?

From the IRS point of view passive income is any income that you get without having to materially participate in. Passive income is money obtained on a regular basis with little effort. Examples include:

• Rental income
• Renewal income – income from subscription renewals
• Royalties – from book publishing, patents, etc.
• Advertising income – from online ads such as Adsense
• Business income – from nondirect involvement in a business such as limited partnerships
• Dividends and interest income
• Pensions

Tax Benefits

Unlike earned income, passive income has great tax benefits. Earned income is subject to self-employment tax which is just over 15.5% (if you’re a W2 employee, your employer pays half of this). Passive income isn’t subject to this tax. If you own rental property, you also claim depreciation. Depreciation is the replacement cost of equipment used in a business and is spread out over its useful life. For residential real estate, the IRS deems the useful life to be 27.5 years. However, the useful life of a house could well exceed 60 years. This results in you being able to claim a tax loss which doesn’t really result in any loss to you. Because of this, depreciation losses are sometimes termed as phantom losses.

Rental Income Example

Let me give an example. Suppose you buy a rental property for $325,000. The tax bill says the land is worth $50,000 and the improvements (everything else that’s built on the land) are worth the remaining $275,000. Based on the IRS’s straight-line depreciation method of deducting the cost of the improvements over 27.5 years, you get to claim $10,000 a year in depreciation. Assuming you have a mortgage of $275,000 at 5%, you’ll pay about $13,750 in mortgage interest payments. Assuming the property tax rate is 1.5% and the insurance and miscellaneous expenses are another 0.5%, you’ll be paying another $6000/year. You have total actual expenses worth $19,750 per year plus depreciation loss of $10,000 bringing your grand total to $29,750. If you’re getting $1750 per month in rent, that works out to $21,000 worth of rental income. Since your actual costs are $19,750, you’re making a profit of $1,250. However, according to IRS passive income rules, you’re technically making a $8,750 loss!

Not only do you not pay taxes on your $1,250 worth of rental income, but you also get to deduct the $8,750 phantom loss from your regular earned income! In a 30% tax bracket, that is a $3,000 tax saving! You can deduct up to $25,000 worth of passive income losses on your taxes every year! If you have more losses, you can carry these forward until you can offset them against passive gains (like the sale of the property).

The flip side to this rule is the depreciation recapture rule which means you need to add back in the depreciation losses when you sell the property. However, this can be somewhat avoided by the use of a 1031 property exchange (also called a Starker exchange).

Stock Dividends

Qualified stock dividends are also another form of passive income that attract favorable tax rates. Instead of being taxed as ordinary income, the maximum tax rate is now 15% for most people. In fact, if your tax rate is 10% or less, you’ll pay only 5% income tax on your qualified dividends! There are certain restrictions that come with these lower taxations. The corporation issuing the dividends must be a domestic US corporation or a qualified foreign company. There is also a holding period of 60 days before the ex-dividend date and 59 days after the ex-dividend date.

Partnerships

Partnership income, from master limited partnerships (MLP) for example, generally has depreciation or depletion credits that lower the cost basis of your purchase.

The IRS definitely gives a lot of tax benefits to passively earned income. If you get paid as a W2 employee, you have the least number of tax breaks and will usually pay the highest taxes.

Please consult your tax adviser before you make any financial decisions. If you’re subject to exemption phase-outs or AMT this advice may not apply to you.

HOLDRS were created by Merrill Lynch in 1998 and sold on the American Stock Exchange (AMEX). They are trust–issued receipts that represent your beneficial ownership of a specified group of stocks. Although the HOLDRs trades like an ETF, it behaves a bit differently. HOLDRs are trusts and not registered investment companies, which means the underlying stocks included in the HOLDR do not change except for spinoffs, or mergers and acquisitions.

For example, UTH is a utilities HOLDR holding 18 top companies in the utility industry.

Dividends are paid when the underlying stocks pay their dividends so you may get several dividend payments in a month.

Risks

Unlike ETFs, Merrill Lynch determines the composition of each HOLDR and the individual stocks’ initial weighting. One HOLDR can vary radically from another. For example, stocks in some are initially equally weighted, while other HOLDRs’ allocations are based on such parameters as market cap, liquidity, and price-earnings ratio.

HOLDRS do not track an underlying index like index funds do; they are a static basket of stocks in a particular industry.

One minor inconvenience: You have to buy the HOLDR in 100-share lots. For example, UTH was around $92 on 14 Jan 2009 which means it would cost $9,200 plus the brokerage commission to buy 100 HOLDRs of UTH.

Advantages

When an issuer spins off a new security, an owner of a HOLDR receives that security in their brokerage account outside of their HOLDRS investment.
When you buy a HOLDR, you’re actually buying shares of the stocks themselves, not a fund, so you pay little or no annual fees.

HOLDRS have no hidden capital gains — you owe taxes only on gains that you actually realize.

You don’t have to pay management fees of any kind. Your only expense comes from transaction costs and from a small annual custody fee taken against cash dividends and distributions, when they are issued. This annual custody fee is eight cents per HOLDR, and will be waived if no dividends or cash distributions are paid on any of the underlying stocks.

HOLDRS are exchange-traded and are priced throughout the trading day just like any other stock so you can buy or sell at any time.

HOLDRS were designed to be a less costly, more tax-efficient way for investors to purchase, hold and transfer securities of selected companies in a particular industry, sector or group.

You retain the voter rights of individual stocks in a HOLDR.

Tax Benefits

The ownership feature of HOLDRS creates powerful tax advantages:

• Avoid embedded capital gains. A recent Morningstar study showed that embedded capital gains represent 34% of net asset value for large index funds with below-average turnover. That means if you purchase one of these index funds, you might eventually have to pay taxes on more than a third of your initial purchase, even though you may have purchased the index fund too late to benefit from the rise in stocks that triggered the tax liability. You can eliminate your exposure to embedded capital gains through the ownership structure of HOLDRS. With HOLDRS, you owe taxes only on gains that occur after you buy your shares. Your capital gain or loss is simply the price at which you sell minus your total investment.

• Limit taxes resulting from turnover. The composition of your HOLDRS doesn’t change, except in special cases like corporate mergers, acquisitions and other specified “Reconstitution Events”. As a result, the buy-and-hold feature of HOLDRS limits taxes resulting from portfolio turnover.

• Control realization of gains and losses. Some investments create tax liabilities that the investor cannot predict or control. With HOLDRS, you control when and how you realize capital gains and losses.

• Personalize tax strategies. With HOLDRS, you can fine-tune your tax exposure easily. You can buy or sell your entire HOLDRS to realize overall gains or losses. Or you can exchange your HOLDRS for the underlying stocks and realize gains and losses in the individual stocks you select. For example, you can take tax losses in any stocks that have declined. HOLDRS are unique in that they allow you to defer taxes on your best-performing stocks indefinitely. And HOLDRS do not cap any big winners.

You should consult your own tax advisor.

Are you worried if your bank is safe? See how your bank or credit union rates with Bankrate. Their proprietary Safe & Sound ranking system rates banks on financial strength and stability. They apply 22 tests to a financial institution to measure:

• Capital adequacy
• Asset quality
• Profitability
• Liquidity

Though not an exclusive piece of information to make a banking decision on, it is very helpful to see where your bank rates. Note that these rankings are updated quarterly.

Another handy link is the one to the FDIC in which you can tell if your bank is FDIC insured. You can learn how deposit insurance works, find out whether your bank is FDIC insured, and other important tasks.

Doug

This chart shows the price swing for certain asset class proxies in 2008. The price swings are roughly correlated to total return or loss: the more price swing the more you can expected in total return. Even though standard deviation and beta are another approach to measuring volatility, watching the price swing is something most people do on a regular basis. After looking at these price swings no wonder people fret when thinking of investments.

Ranked by total return.

Doug

Note:

%price swing = (high – low) / low

which was taken from Vanguard’s calculation of price swing.

Stable value index and passbook rate are of 11-30-08.

I know this is premature but it will be updated as soon as the information is available.  I think this information is very educational and shows how large many of the yields have grown. Also this may help in last minute planning for 2008.

2008 Total Returns Chart

The long term treasury rate dropped about 2% in 2008 which is why the total return was so remarkable.

Notes

Yields are as of 12-24-2008. Total returns updates are indicated.

VBMFX – proxy for Barclays US Aggregate Bond Index. The broadest measure of the taxable U.S. bond market, including most Treasury, agency, corporate, mortgage-backed, asset-backed, and international dollar-denominated issues, all with investment-grade ratings (rated Baa3 or above by Moody’s) and maturities of 1 year or more.

Stable Value Index – Heuler Stable Value Pooled Index. The average of top quality stable value trusts.

Everyone needs utilities. Here is a list of utility funds.

Utility Funds

IDU – Dow Jones U.S. Utilities Sector Index Fund (ETF). The Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Dow Jones U.S. Utilities Index. 0.48% expense ratio.

XLU – The fund invests in companies involved in water and electrical power and natural gas distribution industries. 0.24% expense ratio.

UTH – Utilities HOLDRS. The trust holds shares of common stock issued by specified companies that, when initially selected, were involved in the utilities industry. No expense ratio.

VPU – Vanguard Utilities (ETF). The fund seeks to track the performance of the MSCI US Investable Market Utilities Index, an index of stocks of large, medium-size, and small U.S. companies within the utilities sector. 0.25% expense ratio.

Here is a list of dividend ETFs and mutual funds in alphabetical order, according to their stock symbol.

Dividend ETFs and Funds

DVY – Dow Jones Selected Dividend Index. The investment seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Dow Jones Select Dividend index. The fund uses a representative sampling strategy to try to track the index. The index is comprised of one hundred of the highest dividend-yielding securities (excluding REITs) in the Dow Jones U.S. Total Market index, a broad-based index representative of the total market for U.S. equity securities. 0.40% expense ratio.

PEY – High Yield Dividend Achievers. The investment seeks investment results that correspond generally to the price and yield (before the fees and expenses) of an equity index called the Dividend Achievers(TM) 50 index (the “Index” or the “Underlying Index”). 0.60% expense ratio.

PFM – Dividend Achievers. The investment seeks results that correspond generally to the price and yield (before the fund’s fees and expenses) of an equity index called the Broad Dividend Achievers(TM) index. The fund normally invests at least 80% of total assets in common stocks of companies that have raised their annual regular cash dividend payments for at least each of the last 10 consecutive fiscal years. 0.60% expense ratio.

PHJ – High Growth Rate Dividend Achievers. The investment seeks results that correspond generally to the price and yield (before the fees and expenses) of an equity index called the High Growth Rate Dividend Achievers index. 0.60% expense ratio.

SDY – S&P Dividend. The investment seeks to replicate, before expenses, correspond generally to the price and yield of the S&P High Yield Dividend Aristocrats index. 0.35% expense ratio.

VYM – Vanguard High Dividend Yield Index Fund (ETF). The fund tracks the performance of the FTSE/ High Dividend Yield index. 0.25% expense ratio.