Myths On Money

This post is a follow-up for MythTip: Recession Part 1. If you are nearing the time when you want to pull out your money from your investments, then bonds might be a good way to take advantage of a down market and lock in good interest rates for the future. This post will take a look at the interest rate gains that bonds can provide, and what to look for in a bond.

What is a Bond?

A bond is kind of like the opposite of a stock. When you buy a stock, you buy a piece of the ownership of the company. When you buy a bond, you are lending money to a company. When you buy a bond, you receive interest on the money that you lend to the company. These payments are typically made on either an annual or semi-annual basis, although other payment arrangements certainly exist. When the bond matures (read below), you get your full purchase price back.

Why Invest in Bonds

The return that bonds provide are dependant on a lot of factors, but many times they will be good investments when stocks are poor investments. Bonds can provide gains both from the interest paid to the bondholder and from potential increases in the price of the bond. This dual gains capacity is what really provides bonds with the ability to provide strong returns in a down market. Consider adding bonds to your portfolio when the stock market is performing poorly.

Bond Language

The words used in describing bonds and the returns they provide can seem like a totally foreign language. Here are the important terms you need to know about bonds. These will help smooth the future discussion.

• Price: This is the price you pay for the bond. Bonds can sell at face value, a discount, or a premium. More on bond pricing in the next mythtip in this series.
• Coupon Rate: This is the interest rate that the bond will pay. It is a percentage of the original price of the bond that is paid each year. i.e. a bond that originally sold for $1,000 with a 7% coupon rate will pay $70 per year.
• Yield to Maturity (YTM): This is the effective interest rate that the bond will pay if you buy it at it’s current price.
• Callable: A bond that is callable can be recalled by the company any time if interest rates for bonds drop. A callable bond is significantly less preferable than a non-callable bond because the call option makes it so that if you are getting a high return, the company can take that high return away from you an replace it with a lower return.
• Rating: This is very important. There are several companies that look at all the bonds that are issued and rate the riskiness of the bond based upon the relative strength of the company that issued the bond. Ratings are alphabetical: AAA is the best, then AA, A, BBB, BB, B, etc. Bonds with a rating below BBB are considered junk bonds, and are significantly riskier than bonds with ratings higher than BBB. Bonds with ratings higher than BBB are considered investment grade. It is not recommended for anyone except serious speculators to buy junk bonds.
• Maturity: This is the time period over which the bond will pay interest. At the end of the maturity period, the company will return the purchase price of the bond.

How They Work

Bonds are very complex. Many finance students struggle to understand the financial calculations and the logic involved with bonds. YTM calculations are among the more difficult calculations in all of finance because the logic behind the calculation can be quite confusing. Fortunately, you do not have to be able to make bond calculations in order to be able to make good bond-purchase decisions. Let’s take a look at an acutal bond today to help you get an understanding of what to look for in a bond.

ALLTEL corporation issued this bond in June of 2002. The original price was $1,000 per bond, the coupon rate is 7.875%, and the maturity date is July 2032. So this bond will pay whomever holds the bond $78.75 each year. Today, the price of the bond is $872.50. This bond is selling at a discount because current coupon rates for a comparable bond today are higher than the coupon rate of this bond (if that didn’t make sense, don’t worry, I’ll address bond pricing in the next post). The bond is rated “A”, so it is of moderate-to-low risk relative to other investment grade bonds. This bond is NOT callable.

Now let’s look at the YTM. The YTM for this bond is 9.816%. This is the important factor. The YTM determines how what interest rate you will actually earn if you buy the bond today. The reason the YTM is higher than the coupon rate is because the bond is selling at a discount. You will only have to invest $872.50 in order to get $72.50 per year. That is a 9.816% return. And this return is guaranteed for as long as the company is in business. In July 2032, you would get the original purchase price ($1,000) back. That is not a bad investment by any stretch of the imagination.

Bond Basics Summary

There are certainly times when bonds are more attractive investments than at other times. Consider bonds at times when the stock market is performing poorly. When stocks are doing poorly, people begin moving their money into bonds. This increases the demand for bonds and forces the interest rates on bonds up. But don’t forget that when stocks are low, it’s also a good time to buy stocks. Either way could be profitable, but bonds are certainly the less volatile way to attempt to cash in on a down market. When looking for a bond, look for a high YTM with a good rating. If you can find a bond that meets both criteria, then look for a non-callable bond. Also keep an eye on the maturity date. Longer maturity dates can be good to lock in your return for a longer period of time, but they also tend to have lower returns, so keep an eye on that as well.

What is a Recession?

A recession is technically defined as two or more consecutive quarters of declining GDP in an economy. GDP is a measure of all income for the economy. For most people, though, a recession can be defined more easily. It is any time when jobs are scarce, companies are failing, stocks are plummeting, and things are generally not-so-hot in the economy. When people hear the word recession, they tend to feel pangs of fear and uncertainty. Will their job be cut? Will their savings hit the tank? Will they lose their home? These are valid fears. And, while there is not much to be done about the potential for job losses and your home’s safety depends upon your past financial behavior there are ways that you can protect your investments when the market is down. There even ways to improve your portfolio over the long run. This post is the first of a short series about how to deal with a recession. This post will focus on what you can do to protect your funds that are held in stocks.

MythTip 1: Avoid the Problem

Just get out before the market crashes. This one seems obvious, but can be very difficult to implement because no one really know exactly when the market will take a dive. It is nevertheless the easiest way to deal with a down market. If you suspect the market could be going down for the count, then get out while your stock values are still high.

Here is a very useful tip for determining when to get out of the market and when to get in. The Federal Reserve, among other things, determines what the base interest rate for the economy is going to be. Theoretically, the members of the Federal Reserve Board should be among the best economists in the country, and have access to the most information pertaining to the economy. When the Fed reduces the base interest rate three times in a row, it is a signal that they expect troubled times ahead and you should get out of the market. Just look at what they did for interest rates recently. Since June of 2006, the Fed has lowered interest rates 10 consecutive times in efforts to curtail the emerging recession. If you had pulled your money out of the market and into a cash account after the third consecutive interest rate drop on October 31, 2007, you would have pulled out when the Dow had a value of 13,930 and avoided the plunge to 8,577 (the closing value of the Dow on October 15, 2008). You would have dodged a loss of value of 38%. When do you get back in? When the Fed raises interest rates 3 consecutive times. This strategy is not the most precise, but it is the easiest to understand and implement, and it works. For more information on the Fed and it’s functions, read this post.

MythTip 2: Pick Your Circumstance

I know what you’re thinking right now. “That was no help, my accounts are already down!” Right? For most people, this is the case. It is too late already in this particular recession to pull out. It just is. But that does not mean that you should not pull out. It also does not mean that you should stay in the market. All it means is that you have to now decide from the following options which best suits your circumstances.

1. Close your eyes and keep your faith. This strategy is primarily for people that have at least 15 years before they plan on cashing in their accounts. If you fit into this group, then here is what you do. You keep investing. Keep putting money into the market. If you have a well diversified portfolio, then your accounts will gain their value back and you will not want to miss out on investing when the market is in its current condition. What’s that you say? The market is still struggling? Why should you put money into it only to have a fair chance of it going down in value again? The answer is so very simple, you may be astonished. The cardinal rule of investing is this: Buy low, sell high. Simple, right? It is simple. But it can be very hard, and it requires courage and faith in the economy. Right now, stocks are CHEAP. VERY cheap. Many stocks are at 50% or less of the value they held only a year ago. Can you say, “Blue light special on aisle 4″? For the same amount of money, you can get almost twice as many stocks as you could have a year ago. What does that mean? It means that if you buy these half-off stocks, then when they rise again to more normal levels, you get to keep the increase in value.

   It will be hard to watch your accounts continue to dwindle. You may wonder why you are putting money into something that is losing value. In order to help you sleep at night, I suggest not looking at your balances each month/quarter, and instead focusing your attention on the future. You are investing for the long-term. Don’t let the bumps and dips of the present sway you from your ultimate goal. If you continue to invest even when the market is down, you WILL get the end result you want. Remember that a loss in the stock market is only a loss when it is realized. To realize a loss means that you sold something for less than you paid for it. If you hold the stocks that are low in value, your account value will look low on paper, but you will not have actually lost any money at all! Think of it this way: suppose you bought a Michael Jordan rookie card for $200. The next year, you want to sell your card, but find that it can only be sold for $100. You might be upset and think you have lost $100. However, you do not need to sell your card, so you decide to hold on to it for a while longer. In fact, you decide that since cards are so cheap right now, you also want to get a Magic Johnson rookie card for $100. Now you have two rookie cards that you paid $300 total for. The next year, you find that both of your cards have regained their value and are now worth $200 each. You sell them and gleefully pocket $100. Did you lose money when your MJ card was low in value? Nope. If you have sold the card for $100, then you would have lost money, but since you held the card until it rose in value again, you didn’t actually lose any money at all. And, since you bought the Magic Johnson card when it was cheap, you actually managed to profit from the slump in basketball card values! The same holds for stocks. If you sell them after a market crash, then you lose money. If you hold the stocks until they return to their original value, then you have lost nothing. And if you buy stocks when they are low and hold them until they are high, then you have made money. For more information on the benefits of continuing your investments, read my post on dollar-cost averaging.

   Please note: this strategy is effective ONLY for people who have many years of investing ahead of them. People who need their funds in 5 or 10 years may not be able to afford to wait for the market to rebound. Do not fear, the market will rebound. If you want/need your investment money that soon, they you probably should not use this strategy, because you may lose more money before you begin gaining. Those with longer investment horizons can afford those losses but you cannot. For you, a more conservative approach is in order.

2. Play it Safe. This strategy is for those who need to preserve the value of their accounts now because they need the money soon. It also is a good strategy for people who simply cannot bear to watch their account values drop any further. This strategy is a little simpler to understand. Just pull your money out of the market. That simple.

   The problem is, where do you put it? I suggest using a cash account. What is a cash account? It is any account with a guaranteed positive return. This includes: savings accounts, checking accounts, CD’s, some money market mutual funds, and a plethora of other accounts that are essentially the same but have dozens of unique names. Most brokerages actually have a high-yield money market account that they will put your money into whenever you pull it out of stocks. The yields on these are fairly competitive with any other high-yield savings account you might find at your local bank. While the returns are low (typically 2-5%), they are MUCH better than sustaining losses. By pulling out, you can maintain the value that you have without risk of losing any more.

   Want to take advantage of the low price of stocks? Don’t worry, if you follow this strategy, you still have a chance of getting the big returns. You can keep making your regular deposits into your investment account (those funds will simply be added to the cash account). When the stock market looks to be picking up, you simply get back into the market. But be careful. Sometimes the market seems to recover, only to drop again a week later. To be safe, do not get back into the market until the Fed raises interest rates at least twice in a row. Three times to be extra safe. While you probably will miss the very best days to be in the market that the people who stay in the market get to cash in on, you can still capture much of the gain in value that the market experiences as it surges out of recession.

The Word on the Street:

Everyone seems to believe that the only way to get good credit to qualify for a necessary loan (usually a mortgage), they have to use credit cards, get auto loans, etc in order to get a good interest rate on future loans.

The Truth:

Your history of repaying debts is a relatively small portion of the considerations lenders make before offering to extend credit to a potential borrower. In short, a bad credit history can sink your hopes of getting a good loan, and a good credit history can certainly help, but a neutral (or non-existant) credit history will not preclude you from qualifying for a loan when it really matters because there are other, more important considerations.

Doubt me? Let’s take a look at the attributes and procedures used by lenders to determine a would-be borrower’s credit-worthiness.

The Three “C’s”

The only concern of the lender is your ability to repay the loan along with any related expenses. To assess this ability, lenders often look at the three C’s of credit:

Character

How you have handled yourself in previous financial dealings. This includes not only your credit history, but how reliably you have paid all of your financial obligations, including rent, utilities, alimony, etc. Your credit character helps the lender get an idea of whether or not you WILL repay the debt.

Capacity

Refers to your ability to repay debt out of your future income. Here, the lender looks not only at your income but also at future commitments that might restrict it. These commitments are almost always debts, although some commitments are non-debt related (such as alimony). Your credit capacity gives the lender an idea of whether or not you CAN repay the debt. This differs from the character portion of the analysis, where they simply want to see if you have been reliable in the past. In most cases, your credit capacity will be the most important factor that determines whether or not you qualify for a loan, for reasons that I hope will become obvious with an example.

Suppose you have the opportunity to loan money to one of two people. The first borrower, Jack, has a great credit history. He has carried lots of debt for a long time, and has never once failed to make his payments. The problem is, Jack spends most of his income on debt payments, and barely has enough extra income to make payments on your loan. The other borrower, Minnie, has only a small credit history. She has not debts whatsoever right now. A quick check show you that she has been very consistent in paying rent and utilities, indicating that she takes her financial obligations seriously despite having rarely incurred such obligations. She has plenty of money each month with which to repay you. Who would you give your money to? Personally, I would give it to Minnie because she actually has the ability to repay, and has not demonstrated a propensity for fiscal irresponsibility. Jack has managed his obligations well, but he has no wiggle room for your loan. The slightest mishap in his finances would cause him to lose the ability to repay you.

Capital

Refers to your financial strength, usually measured by net worth. Net worth is a financial term that simply means how much you own (assets) minus how much you owe (debts or liabilities). Essentially, this is a measure of how much money you would have left if you were to sell everything you own and repay all of your debts. This is an important consideration when looking at whether or not to lend money. If the borrower has extra funds or assets that he could potentially sell to repay the lender, then this reduces the risk that the lender will never get their money back in the event the borrower faces financial difficulty. Like the credit capacity rating, the credit capital rating measures whether or not you CAN repay the debt.

As you can see, only one of the three factors considered above pertain to your credit history and whether or not you WILL repay the loan. The lender is much more concerned about whether or not you CAN repay the loan, as measured by the capacity and capital components of credit-worthiness. Notice also that use of past debt is only a portion of the character component. In essence, it might be said that your use of credit in the past constitutes less than 33% of the considerations made when you apply for a loan.

This is not to downplay the importance of the character component. Certainly, if you took a test and missed 33% of the questions, you might be a bit disappointed in your score(well, I guess it depends a bit on which subject the test covered….66% might be a great score for some classes!). But it is important to realize that you do not have to go into debt in order to satisfy the charcter requirements. By simply showing that you have handled your finances responsibly, you can satisfy the character component.

How can you build your character score without going into debt? First is to take care of your obligations. Everyone has financial obligations, even if they have no debt. Pay your rent, make your utility payments, pay your taxes (and on time!). Next, take advantage of the fact that the three components are very interrelated. Your character score can be much improved by simply taking care of your capacity and capital scores. Think about it; if you see someone who has taken on a great deal of debt, and has maxed out credit cards, would it surprise you to learn that they had been evicted several times from various apartments? It wouldn’t surprise me. What if you saw someone who had a wad of cash in savings and whose income far outstripped their living expenses? Would you consider that person likely to take care of their financial obligations? I certainly would, and I would be much more inclined to lend that person money even if they had no past history of repaying debts. That person has improved their capacity and captial scores to the point where few would doubt their willingness to pay off their debts. And that’s what lender’s really want, isn’t it?

Risk and Return

The topic of investment risk and investment return could occupy an entire college semester (I have, in fact, attended just such a class). For the purpose of this post, I will just touch lightly on this topic to help you get an idea of how and why banks charge higher interest rates to some people, and not to others.

It is one of the most, if not the absolute most, fundamental principles of investing that higher returns cannot be gained without taking greater risk. In the stock market, higher risk is usually found in the volatility of a given stock; the chance it might go up by a large amount is offset by the fact that it might also go down by a huge amount. This principle becomes intuitive when we pull it out of the financial arena and bring it home in terms we see every day.

Suppose you were in Las Vegas with $100 in hand, and were considering which game upon which to place your bet. In one game, the dealer draws a card from the deck. If the suit of the card is a spade or club, then you win $200. If it is a heart or diamond, you win nothing. In the other game, a giant wheel with 100 slots in it is spun. If it lands on the number you picked, you win $200. Which game would you play? You would play the card game because it gives you the best chance (50% compared to 1%) of winning the same prize. Now let’s change the scenario a bit. Suppose instead of winning $200 on the wheel game, you had a chance of winning $1 million dollars. Now which game would you choose? It’s a harder choice, isn’t it? The card game is far less risky (because you have a 50/50 chance of winning), but the wheel game has a far greater reward. You would expect the games to be structured more like this because it doesn’t make sense for you to take more risk for the same reward, when you could take less risk and still get the same reward. This is the relationship between risk and reward(return), and it holds true in Vegas just as easily as it holds true in the stock market, the bond market, or even the mortgage market.

You are an Investment

You need to keep in mind that when you apply for a loan, the lender is not looking at YOU and deciding if YOU can have the money or not. They are looking at an investment, pure and simple. They want to invest their money in you. If you are a risky investment (i.e. with a low chance of repaying), then they will want a greater return in order to justify investing in you. They get that return by offering you a higher interest rate than they would to someone who was “less risky”. That is why it is important to make yourself appear as though you can repay them. If you look like you can repay them, then you most certainly can because lenders are very thorough and will find out if you cannot repay. So, when trying to qualify for a great interest rate on a loan, just think about what YOU would want to see in someone that you were considering loaning money to. Chances are, your lender will be looking for much the same thing.

The Word on the Street:

There is an almost universal and constant complaint that political leaders (particularly the U.S. President) have destroyed the U.S. economy, and if there were a change in leadership things could immediately improve.

The Truth:

A free-market system (like the one in U.S.), almost has a mind of its own, and cannot be directly controlled or manipulated. Such control is only possible in a socialistic economy. While there are some aspects of a free market economy that can be influenced by politicians, the market as a whole is controlled by each individual. It is controlled by you and by me.

(This post attempts to compress the critical points from many courses of economics and finance. All references refer to the economic system in place in the United States.)

Free Market?

A market is a place where goods and services may be exchanged. When economists speak of “free” markets, they mean that the prices and terms of exchange in the market are controlled exclusively by the forces of supply and demand. The more of a good that is demanded by the buyers, the higher the price it can be sold for, and vice-versa. Likewise, the more of a good is or can be supplied by producers, the lower the price of the good, and vice-versa. This is fairly intuitive; if your friend has 100 cookies and you want one, he may well give you one for free, but if he only has one cookie and you want, you may have to offer him a lot for it.

So, in a free market system, the prices of goods are dependant upon how much of a good is demanded, and how much can be produced. When you buy a gallon of milk, you create demand for milk and help drive the price up. When farmers have a good crop of corn, the supply increases and corn will be cheaper. Now, the influence of an individual is small relative to the size of the market (in the U.S., it’s millions and millions of people), but our individual buying habits collectively come together to determine how the economy operates.

So What Can They Do?

There are a few aspects of the economy that can be influenced by political policy. However, bear in mind that the actions listed here do not effect the economy in the same way that turning the wheel effects a car. A closer comparison would be to say that it is like steering a horse by dangling a carrot in front of it. Just because a certain action should have a certain effect does not mean that it always will; there may be stronger influences to affect the course of the economy. These tools simply apply pressure to the economy to try to stimulate it to move in certain directions.

1. Interest rates. This is probably the most important and effective tool the government has for influencing the economy. The Federal Reserve board meets regularly to decide what the base interest rate for the country should be. The lower they set the rate, the cheaper money becomes. Interest rates on loans drop and money becomes easier to get. This causes spending to increase, which tends to push stock prices up and gives the economy a boost. This boost does not come without a price, though. With increased spending, inflation begins to become more of a problem. In the current economic slump, interest rates have been lowered to all time record lows in order to encourage spending and the issuance of mortgages.
   
   Raising interest rates has the opposite effect. It makes money more expensive, puts pressure on people to reduce spending, which cuts into the earnings of companies and can depress stock prices. On the bright side, it makes it so that consumer deposit accounts (i.e. savings accounts) yield higher returns, and tends to tamp down on inflationary pressures. The Fed may soon be forced to raise rates in an attempt to curb rising inflation, but even should they do so, it is unlikely that the current inflation in the economy will subside completely. Raising the rates will likely slow the inflation rate, but not stop it in its tracks. This is because there are other forces at work (like the rising price of gas [caused by rising world-wide demand for oil and by speculative pressures]) that are causing inflation.
2. Trade Policy. This is a area that is also very important. Trade is a wonderful thing because it generates wealth for everyone involved. By trading goods and services, both parties can come out better off for the exchange. By maintaining free trade laws, the U.S. can import goods at a lower price than it could manufacture them for, and can export goods which it can produce cheaply. Thus everyone winds up buying at the lowest prices possible. By enforcing trade barriers, the price of foreign goods goes up in the U.S., and the quantity available in the U.S. declines. Think about how often you buy foreign products like Sony TVs, Honda cars, Chinese made toys, etc and you begin to understand the ramifications of impeding trade. The effect of barring trade can be huge.
3. Industry Support. This one has come into the limelight with the mortgage crisis. There are times when the government can step in to help an ailing industry. Lately, it has been mortgage lenders who have been the recipients of government aid. Government aid can come in many forms. The ethanol industry has been benefiting from governmental subsidies; basically, the government has been giving money to ethanol producers because they cannot yet produce ethanol profitably. Once (if) the ethanol industry becomes established, the subsidies will cease and an entire industry will have been born which could otherwise have never gotten off the ground.
4. Regulation. One of the government’s most visible roles in the economy is the establishment of regulatinos that companies must adhere to. Such regulations are usually intended to help protect the public interest. Because a company (and insurance company, for example) has more intimate knowledge of the products and services it provides, there is an opportunity for the company to exploit an ignorant consumer. Government regulation helps prevent this. Government regulation can also be used to protect the environment or other public concerns. Such regulation may hinder a company from realizing it’s maximum profitability potential, but protects those who otherwise might not be able to protect themselves.
5. Taxes. Of course changing how much people and companies pay in taxes also effects the economy. By reducing taxes, companies become more profitable and consumers find themselves able to purchase more. This helps promote growth in the economy, but can also pose a hindrance to government spending. A healthy balance must be maintained so that the economy does not overpay in taxes, and the government can still have enough funds to accomplish it’s purposes.

Who’s To Blame?

Everybody wants to blame someone else for the economic slump in the US, but really, we have only ourselves to blame. Companies that issued sub-prime loans should not have issued them, true, but those who took the loans should not have taken them because they could not afford them. Why are banks going under? Is it because borrowers are not paying their loans? Yes, in part. Borrowers should not have taken debt which they could not afford. But there is a second part to the story of bank failure, and the recent collapse of Bear Stearns (one of the premier Wall Street brokerage firms) illustrates the problem. Bear Stearns was in great financial condition, and still is. So why, then, was it sold to JP Morgan Chase? The answer: lack of cash. Bear Sterns has tons of assets, but it ran out of spendable cash to pay its own debts with. This is the same problem many of the banks are facing. Why are banks running out of cash? Part, as stated above, comes from delinquent loans. But the other part comes from a lack of personal savings. Banks get their money from their members. If members save $10 million in a bank, then the bank has $10 million to work with. With savings rates pitifully low over the past several years, banks have been running out of money, and without money in their coffers, the banks cannot meet all of their obligations and are forced out of business.

So What is to be Done?

The change in the economy must start inside every household in the country. All of us must take care of our personal finances. We must be careful spenders AND careful savers. We must save money and invest in stocks and bonds so that the banks will not go under and so the stock prices can rise. We must also spend money. It is critical that companies received revenue from sales, or they will go under.

How can we both spend and save? It is not easy, but a critical point in doing so is to be careful in what we purchase. Only purchase goods that you need, only purchase goods that are fairly priced, and, most importantly, only purchase goods that you can afford. It is past overspending that is killing the US economy, one family at a time. Spending in itself is not bad, but spending more than you have is catastrophic, and we are now realizing the full consequences of our habits.