Why is this Topic Important to Wealth Managers? Today we continue our series on “Wealth Management in Today’s Economic Environment”. The series is designed to address the specific question many wealth managers are currently asking: “what are the best investment, retirement and financial planning tools given the current global financial position?” We explore alternatives from “safe” to “risky” from “traditional” to “emerging” to discover and discuss the most relevant wealth management tools and techniques available today. We look forward to presenting this discussion and think you will find the information quite valuable. Please note that this series is presented in continuation. That being said each blogticle resumes discussion from the previous day.

Corporate Debt

The dream of the asset manager is to generate high returns (like those available through equity positions) while at the same time providing guaranteed payments through avenues such as debt obligations. Nevertheless, as was discussed in the beginning of this series, the risk/reward model can help determine what investments may work best in today’s economy. Any wealth manager who believes however that bonds have no risk has their head in the sand. All investment actions, including inaction, involves risk in its purest form. For that is essentially the theme of what we learned in Econ 101—“Opportunity Cost”. Even corporate debt can be defaulted upon, and has been recently noted tax-free bonds too face danger of default. Thus risk of default should be considered as one factor among many when determining asset allocation.

It is important to thoroughly understand the financial statements of corporations which are issuing debt. It has been seen that the rating agencies such as Moody’s and S&P have failed investors in the past. Personal responsibility is one key to financial success. Therefore wise wealth managers will complete a diligent analysis of the financial position of a corporation before recommending that position to a client. As one commentator notes, “[a] strong balance sheet can be even more a source of strength and competitiveness in a recession than during a boom.” [1]

One important consideration in this area is the debt to equity ratio. Generally in the corporate world, the “expected debt to equity ratio varies depending on whether markets are bullish or bearish, whether the economic sector to which a company belongs is more sunrise or sunset, or indeed on whether a company is in an early development phase or at maturity.” [2]

Generally, interest that accrues after the date of purchase of a corporate bond is included as ordinary income in the year in which it is received or made available. [3]

For additional information on the taxation of bonds see TaxFacts: Bonds.

For additional information on financial statement evaluation see Advisorfyi.com: Understanding Financial Statements with Warren Buffett.

Tomorrow we continue our series with U.S. government investment.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

Series Author: Benjamin Terner

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[1] Les Nemethy. Debt Versus Equity in Today’s Financial Climate.http://ezinearticles.com/?Debt-Versus-Equity-in-Todays-Financial-Climate&id=2381584. Last Accessed 5/31/11.

[2] Id.

[3] Treas. Reg. §1.61-7.

Why is this Topic Important to Wealth Managers?   Discuses one alternative investment wealth managers are continuing to explore in consideration of uncertain tax law changes.  Provides general background as well as analysis and comparison to show the benefits available through the purchase of tax-exempt bonds.     

Interest received from bonds is generally taxed at ordinary income rates.  This includes both government and corporate bonds unless otherwise excluded by the tax code.[1]  Dividends though are taxed at capital gains rates, which for the meanwhile can provide significant tax benefits.  See our previous AdvisorFYI blogticle of September 13^th Bush Tax Cuts Set to Expire. 

However, some state and local municipal bonds often called “muni” bonds, produce tax—exempt interest income under Internal Revenue Code § 103. The general obligation interest on state or local bonds fall into this category[2] as distinguished from private activity bonds. [3] 

A detailed discussion of private activity bonds in comparison to general obligation bonds can be found at Tax Facts: Q 1123. Is interest on obligations issued by state and local governments taxable? This blogticle deals with general obligation bonds.  A comparison between tax-exempt and taxable income bonds is illustrated with rates of return below: 

“A 4% yield on a muni is the equivalent of a 5.6% payout on a taxable bond if you’re in the 28% tax bracket and 6% if you’re in the 33% bracket.” [4]  The advantage of municipal bonds over corporate bonds is that income from the latter is not specifically excluded from gross income.  Another example adapted from AdvisorFX: [5]

Individual A can chose to purchase, a $1,000 corporate bond with an annual interest rate 7.5%, or a $1,000 state/local bond at 5.5%.  The first option will yield interest income of $750 with a tax of $210 (28% bracket), therefore a net return of $540. The state/local bond will yield $550 and the income is specifically excluded from gross income.  Even though the corporate bond has a higher stated return the muni bond is most likely a better overall investment.  But why are the muni rates lower? 

This tax preferential return allows municipalities to raise money from the investment market at a cheaper interest rate cost.  The “exclusion is intended to benefit state and local governmental units” because the cost of borrowing to these institutions becomes less and in turn “enabling them to market bond issues to investors at lower rates of interest than ordinary private sector bonds.”  Additionally, because “the interest on these bonds is tax-free, investors are generally willing to purchase them at prices that provide a lower rate of return than regular bonds.” [6]

Let’s take a look at another example [7]:

Investor X has $10,000 to invest.  His first option is a triple-A-rated, ten-year muni, which yields 3.43%, and his second option is ten-year Treasury notes, which yields 3.83%.

In all tax brackets, the muni will yield $343.  In the 28% bracket, the after tax income from the T-bills is $276, in the 33% bracket it is $257, and in the 35% bracket it is $249.  Thus, the higher the bracket the more efficient tax-exempt bonds become to an investor in relation to other taxable investments.  In this case the 28% bracket taxpayer saw an greater return on investment of $67, the 33% bracket saw the amount to be $86, and the 35% saw a $94 benefit over the Treasury notes, even though the interest rate yield was a higher stated amount.  In other words, the benefit of purchasing the tax-exempt bonds produced almost 1% (.94%) higher yield over the Treasury notes

Tomorrow’s blogticle will discuss the taxation of life settlement agreements. 

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] 26 U.S.C. § 61(a)(4).  

[2] 26 U.S.C. § 103 (a).   

[3] Municipal Securities Rulemaking Board.  http://www.msrb.org/msrb1/glossary/view_def.asp?param=PRIVATEACTIVITYBOND.  2010.  Last Accessed 10/9/10.

[4] “Tax-Free Bonds”.  Kiplinger’s Personal Finance Magazine.  March 2008.  Jeffrey R. Kosnett and David Landis.  http://www.kiplinger.com/magazine/archives/2008/03/maximize-returns-with-bonds.html#ixzz11tDv5mBV.  Last Accessed 10/9/10. 

[5] AUS Main Libraries.  Section 19. Income Taxes.  Subheading 3-“Interest On State And Local (“Muni”) Bonds—I.R.C. §103.”  http://www.advisorfx.com/articles/f19_1_8_3240.aspx?action=13.  Last Accessed 10/9/10.  

[6] Id. 

[7] Adapted from Kiplinger’s Personal Finance, March 2008.