Why is this Topic Important to Wealth Managers? This week 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 starting with last week’s entries. That being said each blogticle resumes discussion from the previous day.

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 (as discussed earlier in this series) are taxed at capital gains rates, which for the meanwhile, can provide a significant tax advantage.

However, some state and local municipal bonds often called “muni” bonds, are tax—exempt 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 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. And these yields are relatively safe. Muni defaults have been rare over the years.” [4] However, some state and local municipalities are currently facing financial difficulties. This may affect the traditional ability of the issuers to pay. See generally though Advisorfyi.com, Change in Muni Bond Market Could Help Producers.

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 Advanced Markets Advisor FX: [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?

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]

Our series continues tomorrow to continue to explore financial planning in today’s economy.

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] 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; 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?

[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.

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.

As was briefly mentioned yesterday with regards to stock equity positions, one analyst recently compared the returns of the S&P 500 against hard assets such as gold and silver (discussed later in this series). His research strategy was to model an investment starting in 1981 where the client would invest $1,000 each year in either the S&P 500, silver or gold at the average price for that year. The returns from the stock portfolio would be reinvested each year in the model. Additionally, the model showed a $1,000 contribution was made each year. [1]

The analysis provided the conclusions that investing in “stocks had been much more profitable in the first 20 years.” For example in the year 2000 the equity index holdings illustrated in the model provided for a 879% greater asset worth as compared to the price of gold and a 774%  increase over the price of silver.

However, since 2004, “precious metals have begun to quickly make up ground and, helped by S&P 500′s 57% crash during the last recession, silver managed to slightly surpass stocks in 2010”.  Interestingly, on “April 28, 2011, when the price of silver was near its peak, silver was a clear winner with a value of $233,917 and a compounded annual return of 11.8% compared to S&P 500′s $173,400 and 10.3%, and gold’s $115,889 and 8.12%.” [2]

The race is tight however, the silver market in particular is known for its volatility which was is still an ever present consideration. The conclusions drawn by the study include, in part, that “the magnitude of compounded rates of return depends a lot on the window of time” that the investor selects.[3] This conclusion is similar to those presented by other investment strategy such as those presented by Sethi (see previous section).

As the S&P 500 strategy may very well reflect, some investment commentators are questioning old models that may no longer be the right path for many investors.

Moreover, as one commentator notes, the traditional approach of selling stocks as retirement age approaches may not necessarily provide the best wealth management solutions. The traditional approach is to “typically tell those near retirement to move to safer asset classes. But stocks are not risky so long as they are selling at reasonable prices, according to [some] research.” [4] The commentator notes what wealth managers should be advising clients to look to valuations and timing to dictate asset class allocations.  In addition, the commentator suggests that “young investors can afford the risk of stocks because they have time to recover from price crashes.” [5] However, it may also be contended that a loss in value of assets caused by price devaluations in the market have a significant negative affect on long-term earnings given time value of money calculations. In other words, “this loss is greater for young investors than it is for any others (because young investors have more time ahead of them in which the compounding returns).” [6]

Nevertheless, as Warren Buffett notes, his investment strategy has never changed, it has always consisted of the motto—investment in companies that are undervalued is a large consideration to successful financial growth.[7]

Finally, there may be tax advantages to using the equity index model over the purchase of precious metals. Generally dividends are subject to special tax treatment and thus provide additional benefit. For detailed tax treatment of dividends see TaxFacts: Dividends.

Tomorrow we continue our series with Corporate Debt and 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] See Sergei Barna. The Best Long-Term Investment: Gold vs. Silver vs. S&P 500. Seeking Alpha. May 20, 2011. http://seekingalpha.com/article/271054-the-best-long-term-investment-gold-vs-silver-vs-s-p-500. Last Accessed 5/29/2011.

[2] Id.

[3] Id.

[4] Rob Bennett. “The Bull Market Caused the Economic Crisis.” http://knol.google.com/k/the-bull-market-caused-the-economic-crisis#. Version: 26, Last edited: Apr 22, 2010. Last Accessed 5/29/2011/

[5] Id.

[6] Id.

[7] See generally, “Understanding Financial Statements with Warren Buffett”. Advisorfyi.com. Posted December 1st, 2010. http://www.advisorfyi.com/2010/12/understanding-financial-statements-with-warren-buffett/. Last Accessed 5/30/2011.