Cigarette makers are required to put health warnings on their cigarette packages.  Maybe the Government should be required to put wealth warnings on its decisions.

Federal Reserve Bank Chairman Ben Bernanke has released a game plan for raising interest rates, and has already started to implement that decision with the Fed raising the Discount Rate on February 19th.  Other rate rises are sure to come, including rises in the Federal Funds rate—it’s just not clear when and by how much.  Rising interest rates mean lower bond valuations for outstanding bonds and higher costs to individuals and businesses carrying various kinds of debt.

The so called Bush tax cuts are scheduled to expire on December 31^st of this year.  Absent legislation (which is unlikely to come from the current dysfunctional Congress), income tax rates, capital gains tax rates, and estate tax rates will rise January 1, 2011. 

Investment accounts need to reviewed and adjusted as necessary in light of these developments.

Starmont Asset Management’s goal is to preserve and grow our Clients’ net worths.

Upcoming changes in interest rate levels and tax rates will make our job more difficult.

Interest Rates

Raising interest rates is the primary mechanism that the Federal Reserve Board uses to fight inflation.  Lowering interest rates is a mechanism that the Fed uses to pump money into the economy and ward off recession.

During the decade that just ended the United States experienced two recessions.  As a result the decade was one where the Fed lowered interest rates to help ameliorate the severity of those recessions. As a result of these activities of the Fed, we ended the decade with the Federal Funds rate at zero.

This had two effects.  It made bonds the best performing liquid asset class during the decade (when interest rates go down, the value of outstanding bonds goes up).  And it set up the current decade as one where interest rates had only one way to go—up (thereby sending the value of outstanding bonds down).

Rising interest rates have other effects as well.  The interest rate paid by new bonds will go up, generating more cash to the holders of those bonds.  And people holding other interest paying investments, like money market accounts and CDs, will get higher interest rates on those investments.  On the other hand, people and businesses with variable rate debt (like Home Equity Lines of Credit or Business Lines of Credit) will pay higher interest rates on those obligations.

Starmont has a number of decisions to make for our Clients’ portfolios:

• Whether to own any fixed income investments in those portfolios, and if so how much
• What kind of fixed income investments to own
• In which kind of Client account (taxable or tax deferred) to own the investments

The last question has to do with taxes. 

Taxes

It’s not what you earn that matters, it’s what you keep.  In making decisions about fixed income investments we are seeking the highest total return for the quality bond in which we are interested.  Total return is:

1. Interest received
2. Less the tax paid on that interest
3. Plus or minus the change in the market price of that investment
4. Divided by the price we paid for the investment

 For example:

• We can buy an intermediate term (5 year) investment grade (not junk) bond for $1,000, which pays a fixed 5% interest ($50) in a taxable account (like a family trust account). Assume the Client is a California tax payer and pays 35% federal tax and 8% California tax.  Assume further that interest rates rise 2 percentage points in the market.  That means that the Client receives $50, less 43% federal and state income tax, leaving $28.50.  The market price of the bond has gone down 10% (the rule of thumb is the change in interest rate (2%) times the duration of the bond (5 years) equals 10% of $1,000, or $100.  The return on the bond is $28.50 less the $100 loss in market value (-$71.50) divided by the $1,000 we paid for the bond, giving us a loss on the bond of -7.15%.
• Same example, except the bond is a 5 year California double tax free municipal bond, or a taxable bond purchased in a tax deferred account.  Here the Client gets to keep the entire $50 in interest, still losses $100 in market value, so the return on the bond is -5.00%.  The loss in market value is mitigated by the absence of taxes.  (And the loss in market value can be caused not only by rising interest rates, but also by the quality of the bond being lowered by the bond rating agencies, a real concern for California municipal bonds given the terrible condition of California’s finances.

The result is the same whether the amount of bonds purchased is $1,000, $100,000, $1,000,000, or more.  Only the number of zeros changes.

Results will get worse in 2011.  Without action by Congress (unlikely in the current dysfunctional Congress) the top federal tax rate goes from 35% to 39.6% (as does the rate on qualified dividends), and the long term capital gains rate goes from 15% to 20%.

What To Do With Client Portfolios

Starmont has made some tentative decisions about how to position our Clients’ fixed income portfolio allocation.  We will be communicating those tentative decisions shortly.  Our view is that the Fed is unlikely to raise rates again before the second half of this year, so that there is time to get input from our Clients before making any changes in Client portfolios.

Contact Us For A Free Bond Analysis

If you would like to have Starmont review your bond portfolio and discuss it with you, please contact us to set up an appointment.  There is no charge for this meeting.

Tags: Bernake, Bond Yield, Bonds, Federal Reserve, Interest Rates, Investments, Taxes

This entry was posted on Thursday, March 4th, 2010 at 6:41 pm and is filed under Blog, The Market. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.