Getting started in bonds 2nd edition phần 5 pps

Otherwise mutual fund managers front-end load mutual fund’s sales charge that is added onto your purchase price.. back-end load mutual fund sales charge that is subtracted from the price

the income every year even if you haven’t gotten it yet Infact, due to any income deferral and the fact that some are

issued as original issue discounts (OIDs), the tax

calcula-tions on these nuggets can be pretty nasty Hopefully,whomever you buy fixed rate capital securities throughwill do it for you

There are three types that differ in how they are sued:

is-1 Preferred partnership securities

2 Trust preferred securities (or capital securities)

3 Junior subordinated debentures

And they are called by a boatload of acronyms:

MIDS Monthly income debt securitiesQUICS Quarterly income capital securitiesQUIDS Quarterly income debt securitiesQUIPS Quarterly income preferred securitiesSKIS Subordinated capital income securitiesTOPrS Trust originated preferred securitiesTruPS Capital trust pass-through securitiesStay tuned for more witty creations

original

issue discount

(OID)

the bond issue

was not issued at

par but instead

8

It’s a Wrap:

Wrapper Products

investment vehicles you can use to invest

in bonds Wrapper products are

ready-made financial portfolios, packaged for individual

in-vestors They’re packaged by insurance companies,

banks, investment firms, and mutual fund companies

that fashion these portfolio packages-to-go for our

convenience

The problem with wrapper products is that there

can get to be many layers (i.e., the financial

intermedi-aries who produce these products) Each layer extracts

its fees, muffling the investment’s performance (See

Figure 8.1.)

For instance, I’ve seen a mutual fund (wrapper

port-folio) that invested in collateralized mortgage obligations

(a wrapper security: mortgages are packaged as

mort-gage-backed securities, and MBSs are then packaged as

CMOs) held in an investor’s wrapper account (explained

later in the chapter) The resulting yield to the investors

was about the same as if they’d gone out and bought a

3-month Treasury bill, but the risk was much greater

Chapter

Even in light of the disadvantages, the advantages are verycompelling

Wrapper products offer:

✔ Low minimum investment

Better pricing because trading in size

Research and market reports from major wirehouses

Pulse on big money’s market temperament

When we invest in most wrapper products, wepool our money together with a bunch of other folksand engage a full-time investment professional to man-age our collective cash The significant size of this potenables the manager to benefit from institutional ser-vice, pricing, and access to information These are ad-vantages we as individuals could never hope to receive

We can buy into a well-diversified portfolio for as little

as $500

FIGURE 8.1 Wrapper products: layers of service fees affect yield.

Drawing by Steven Saltzgiver.

Of course, there is a price for all of these inducements

The cost includes an annual management fee, 12b-1 fee,

and in some cases an additional sales load Management

fees are annual payments charged to cover fund expenses

The 12b-1 fee is to support promotional activities; it is

usually paid out to other firms—for example, broker sales

concessions The load is generally a one-time payment

that is either charged when you invest, a front-end load;

or charged when you sell, a back-end load.

Make sure the fees are reasonable To help ensure

these costs are reasonable, the ever-vigilant Securities and

Exchange Commission (SEC) polices management

com-panies to make sure they clearly disclose all investor costs

in the prospectus which must be given to investors before

they invest So read your prospectus and make sure the

charges look sensible to you

un-usual Now, 2% to 4% is more the norm, and there are

many well-performing no-load funds available

PERFORMANCE

The SEC also regulates how wrapper products report

per-formance so that they don’t overstate their history in

zeal-ous marketing claims When you evaluate a fixed income

product’s performance, you should look at both yield and

total return (See Table 8.1.)

During the 1980s, an outcry from unhappy

in-vestors got the SEC’s attention Thereafter, the SEC

man-dated that in addition to the current yield, funds had to

include the SEC yield in advertisements The SEC yield

is calculated to prevent companies from falsely inflating

the portfolio’s yield by buying high-coupon bonds at a

premium This yield calculation subtracts the premium

paid for the bond from the bond’s higher coupon’s

in-come stream to give a more accurate reflection of the

true yield earned Otherwise mutual fund managers

front-end load

mutual fund’s sales charge that

is added onto your purchase price.

back-end load

mutual fund sales charge that

is subtracted from the price when you sell your fund shares; also known as a contingent deferred sales charge (CDSC).

SEC yield

standardized yield calculation established by the SEC that subtracts the premium paid for any bonds within the portfolio from their higher income stream.

could buy higher-coupon bonds to boost the fund’s

claimed yield This would artificially inflate the yield

be-cause they paid a premium for the bonds and the bonds

would mature at par The SEC recognized the economic

effect that the premium has on the total return

The best measure to use when you’re gauging a

fund’s performance is its total return This includes both

the interest you earn and how much the value of your

principal has changed in that time Here’s an exaggerated

example: You could be attracted to a fund that is yielding

11% Wisely, you look at the total return, which is –2%

because the price is down 13% While past performance

doesn’t assure future performance, it’s smart to check a

fund’s long-term record, and not just invest in what has

been the hottest performer during the last quarter

BOND MUTUAL FUNDS

Mutual funds are the most popular type of wrapper

prod-uct There are more mutual funds than there are stocks

listed on the New York Stock Exchange In 1970, there

were 361 mutual funds; in 2001, there were 8,255 (2,188

of these were bond funds, and many more had some of

their assets invested in bonds)

In 1995, investors had $800 billion invested in fixed

income mutual funds And what do we bond fund

in-vestors look like? The Investment Company Institute

(ICI) tells us that bond fund shareholders’ median age is

44, median household income is $60,000, and median

fi-nancial assets are $75,000; 20% of us are retired and 64%

completed college Whatever we really look like as

indi-viduals, there are two points that are very important for us

to keep in mind when we’re buying shares of a fixed

in-come mutual fund:

✔ Even though it buys fixed income investments,

the fund’s dividend changes.

✔ The fund never matures Its principal value is

al-ways market-dependent

Investment Company Institute (ICI)

private company that monitors the mutual fund industry.

Active portfolio management produces both of thesecharacteristics Since securities are constantly bought andsold and interest rates change, the fund’s payout and yieldare affected And since mutual funds never mature, youare not guaranteed you’ll ever get back the principal youinvested While the number of shares you own stays thesame, the price you would get when you sell them fluctu-ates These points should be carefully considered by in-vestors who are counting on their interest and principalbeing there.

Even when you buy shares of a mutual fund, it is ofpremier importance to understand the securities it invests

in Do not buy a bond mutual fund based on its yieldalone The fund cannot act any differently from the bonds

it invests in Therefore, by understanding the risks andvolatility involved in buying the type of bonds the fund isinvested in, you will understand how the fund will re-spond to changes in the investment environment

There are two general mutual fund classifications:open-end and closed-end The first has no limits on howmany investor shares there are in the fund while the sec-ond has a fixed number of shares

Open-End Mutual Funds Closed-End Mutual Funds

Fund has unlimited Number of shares is set number of shares at issue

Fund size grows and Fund share price rises contracts with changes and falls with changes

in investor demand in investor demand

Investors buy shares Investors buy and sell infrom and sell shares secondary market like back to company stocks

Closed-end fund shares are bought from the fundcompany only in the original offering After that they aretraded on listed exchanges just like shares of stock Fluc-tuations in investor demand don’t affect the closed-endfund manager’s investments The overall size of the fundonly changes with changes in the secondary market of theunderlying securities’ prices that make up the fund

The number of fund shares never varies Each share

has two values One is the market value that it is trading

at on an exchange—the price we would pay for it That

value is determined by how much investor demand there

is for the fund The second value is determined by the

price of the underlying securities that the fund is invested

in This is known as the share’s net asset value (NAV)

Be-cause often a closed-end fund’s market price is well below

the NAV, there is a trend toward closed-end funds

convert-ing into or mergconvert-ing with open-end funds

Open-end mutual funds are the most common

type Either you or your broker buys these funds directly

from the fund company The size of an open-end fund

grows if investors are buying and declines if they are

selling, as well as with security price changes in the

sec-ondary market

Another way to think of the difference is to look at

the equation:

Total $ in fund = Number of shares

× Each share’s NAVWith an open-end fund both factors change; with a

closed-end fund only the second factor changes because

the number of shares in the fund is fixed You can imagine

how the added uncertainty of the open-end fund’s

sce-nario can affect a manager’s investment strategy The ebb

and flow can be dramatic This unpredictable investor

be-havior, and therefore cash flow, can make a fund

man-ager’s job difficult Often, disadvantageous buy and sell

decisions can be forced on the manager since individuals

tend to buy into the fund after prices have become high

and to sell after prices have fallen

Pricing

When you buy shares from or sell the shares back to an

open-end fund company, the price is based on the net

as-set value, not on investor demand The NAV is computed

every night and is the total market value of all the

securi-ties within the fund plus any management fees The NAV

net asset value (NAV)

the dollar value

of all the securities in a mutual fund at the close of the day divided by the number of outstanding shares.

for most funds is available in the Wall Street Journal or on

the Internet If there is a front-end sales charge, it is added

to the NAV when you buy it; and if there’s a back-endsales charge, it is subtracted from the NAV when you sell

it back The NAV adjusted by the sales charge is called thepublic offering price, aka POP

NAV + Front-end sales load = Buying POPNAV – Back-end sales load = Selling POPThis pricing method has advantages over closed-endfunds that trade on exchanges What people think of anopen-end fund has no effect on its share price because thefund will just get larger or smaller with investor demand

or disfavor, whereas the market price of a closed-end fund

is often based more on fickle investor sentiment than onperformance Like any listed stock, the price goes up ordown depending on how much people want to own it.Not understanding how funds operate can cause in-vestors a lot of confusion and managers a lot ofheadaches The following are examples of how this is sofor closed- and open-end mutual funds

Closed-end fund shares can trade at a premium or

at a discount from the NAV, often for reasons that are noteconomically logical When I worked on an investmentteam managing a number of closed-end bond funds, in-vestors would call asking why a fund was trading at adiscount We had no idea, because the funds were per-forming beautifully From an investment point of view,the funds should have been trading at a premium be-cause they had an attractive payout and were outper-forming the bond market However, the fund’s stockprice was trading at a discount because of low investordemand that probably stemmed from not understandinghow to evaluate the fund’s performance If you couldhave raised enough money to buy the entire fund andthen sold the securities in the secondary market, youcould have made a ton of money But, since we don’thave millions of dollars to buy out a fund, we are at thewhims of other investors’ demand

In regard to our open-end funds, the question we’d

get asked a lot had to do with a fund’s share price

drop-ping dramatically overnight In fact, we were asked it at

the same time every month The answer was that the fund

had just gone ex-dividend, meaning the dividend was

paid out to investors and was no longer included in the

fund (See Figure 8.2.) The price of the fund would drop

by the amount of the dividend paid out (plus or minus

any market move) It confused people every month

A little investing tidbit: It’s better to invest after a

fund goes ex-dividend because you’re investing in it

at a lower price If you invest just before it goes ex,

you get the dividend; but you are also paying a

higher price You are paying the fund money that it

then just hands back to you in the form of a

divi-dend that you have to pay taxes on

FIGURE 8.2 Open-end mutual fund price and dividend relationship.

In an open-ended fund the price is also affected bythe changing market values of the securities ownedwithin the fund Every night the securities are valued Fig-ure 8.3 shows how both the price per share of the fundand the dividend change over time This is in contrast to

an individual bond, which has a fixed coupon (so the terest payout does not change) as well as a maturity(when you know you will get the face value back) Thereare no such assurances with a mutual fund

in-Before you buy an open-end fund, the fund companymust send you a prospectus explaining the fund’s invest-ment objective, how the fund invests, and its historicalrecord The trend has been to make prospectuses muchshorter and easier to understand It is in your best interest

to read the whole thing to make sure it’s really what you’relooking for

Performance

There are a number of tools you can use to judge a fund’sperformance You can compare the fund’s yield and totalreturn to those of other funds and to appropriate indexes.Lipper ranks funds according to how they have performedwithin their competitive universe (funds with the sameinvestment objectives and guidelines, such as high yieldcorporate bonds) Morningstar rates fund performance on

FIGURE 8.3 Prices and distributions.

a star system, five stars being the best (See Figure 8.4.)

Both Lipper and Morningstar reports are available at most

libraries Your financial service should also have access to

the information

UNIT INVESTMENT TRUSTS (UITs)

Unit investment trusts (UITs) emigrated to our shores from

Scotland in 1961 Like mutual funds, they enable smaller

investors to buy into more diversified portfolios than they

could buy on their own UITs differ from funds in that they

are not actively managed; a professional money manager is

involved only at the beginning when the UIT is issued The

bonds are bought with the cash raised from selling the

trust’s units to investors The bonds never change and are

held until they mature Up until 1995, most UITs were

fixed income trusts The most popular type of fixed income

UIT has been municipal bond trusts

A UIT’s characteristics include:

✔ Fixed portfolio professionally selected

✔ Steady payout

✔ Known maturity

FIGURE 8.4 Rankings and ratings.

A UIT’s prospectus stipulates what it can invest in,the maturity, the sales charge, and terms for redemption.

It would be correct to say that UITs benefit from sional selection, not from professional management Someinvestors like the fact that someone isn’t meddling withtheir investment There’s no one trying to time interestrates or forecast market sentiment Investors can go tosleep at night knowing exactly what securities they own.The second benefit from a static portfolio invested infixed income securities is that as long as none of thebonds are called or mature, the investors will receive thesame income payout This is unlike mutual funds, whosepayout fluctuates depending on what is owned in the fundduring that payment period

profes-Toward the end of the fixed income UIT’s life, theprincipal is gradually returned to the investors as bondsare called or mature Each unit receives back the sameproportional amount of the principal Since there is lessprincipal earning interest, the income earned will dropcommensurably

If you are considering a UIT, it is very important tonote the maturity dates and potential call dates to makesure the investment still makes sense in view of your long-term goals Does the timing of the principal repayment fityour timetable? Also, keep in mind that callable bondstend to be called when interest rates fall and reinvestmentoptions are less attractive than the investment you were in.The third benefit—a known maturity—means that,unlike with mutual funds, you know you will get yourprincipal back by a certain date UITs usually mature in

5 to 30 years The minimum investment is generally

$1,000 They are not sold on a yield-to-maturity (YTM)basis, but rather on a dollar price basis Their return isestimated using the current return, as well as a more ac-curate long-term return number that takes into consid-eration the securities’ market value, maturity, anddiscount or premium

There is no annual management fee since the trustisn’t actively managed; however, there could be a mainte-nance fee of $1.50 to $2 per $1,000 invested In addition,UITs have historically carried sizable sales charges; but, as

with mutual funds, the size of these charges has declined.

They now typically run about 31/2% to 5% of the total

of-fering price for longer-term trusts It is often difficult for

investors to recognize the size of the sales charge because

it is not broken out but is included in the purchase price,

so ask what the charge is Retail brokers are told by their

management to make you aware of the charges The

charges are also stated in the UIT’s prospectus Since

transaction costs are minimal after the trust is assembled

and UITs don’t continually market their units to the

pub-lic, there are no ongoing management fees or marketing

fees as there are with mutual funds

A UIT’s units can be sold back to the issuer at the

public bid price at any time That price is based on the

value of the underlying securities and could be higher or

lower than the price the investor paid Most trust sponsors

voluntarily maintain a secondary market for their trusts

The sales charge is paid when you buy the UIT, so there

usually is no redemption fee

ANNUITIES

Annuities are another packaged product, but this one has

an advantage in that it allows your earnings to compound

tax-deferred As we have mentioned, this can have a

dra-matic impact on the growth of your investment It is also

likely that when the policy matures you will be retired

and in a lower tax bracket However, as with all packaged

products, be wary

A Wall Street Journal article, “Annuities 101: How to

Sell to Senior Citizens” ( July 2, 2002), chronicles how

“Annuities U” offers courses on how to sell this vehicle

The course is popular since a salesperson who can get a

prospect to transfer $50,000 to an annuity can make a

commission of $3,000 to $4,000 The instructor is quoted

as saying a number of insulting and misleading lines,

in-cluding, “There’s the technical answer and there’s the

se-nior answer Tell them, it’s like a CD—it’s safe, it’s

guaranteed.” In my experience, these words always

war-rant a closer look at what is being touted Sure enough,

the article goes on to caution that, “Annuities are actually

a lot more complex and have downsides that the salesmenmay not mention The higher fees of most annuities canoften cancel out their tax advantages; most annuities lock

in investors for years, and annuities saddle heirs withhigher taxes, unlike mutual funds or most other invest-ments.” Many annuities are mutual funds wrapped in atax-deferred cloak Just be careful, and don’t be rushedinto anything

ASSET ALLOCATION AND

WRAPPER ACCOUNTS

Many investment firms and mutual fund companies offerasset allocation services Here professional managers decidehow to allocate your money among different types of mu-tual funds within their family of funds It’s a service to makeportfolio management easier for you, although with a littlethought this is something you could do yourself Some folksjust feel more comfortable having a professional managerwhose finger is closer to the markets’ pulse make those deci-sions for them Mind you, the decisions aren’t made just foryou but are made for the type of investor you classify your-self as (for example, conservative or aggressive, income orgrowth, etc.)

Another alternative is the wrapper account It is ferent from the wrapper products previously discussed inthat it is an individual’s portfolio, not a pool of many in-vestors’ funds A wealthy individual with a large portfolio($100,000 minimum) has an investment firm hire an out-side adviser For this introduction, the investment firm re-ceives part of the management fee The investor gets amanager who manages the individual’s money with his orher specific goals in mind

dif-CONCLUSION

Wrapper products offer the investor a turnkey investmentalternative Convenience, professional management, and