Dan’s Desk: The Legacy Revealed

When I saw Center founder Dan Boyce’s email offering up his desk and credenza, I knew what I had to do. This was in the summer, as The Center was preparing to move offices, and Dan was getting new furniture. I couldn’t stand to see such an iconic piece of Center history vanish into the night, so, without much hesitation, I went to Dan’s office to inspect the desk and see if I could make use of it.

A Desk with a History

As I expected, there was normal wear and tear from years of use. Dan had leaned over that desk in countless meetings with clients. He had signed off on too many documents to count. He may have even spilled a little coffee on it here and there. But that wasn’t the whole story. Dan told me he bought the furniture in the late ‘80s from his father-in-law, an attorney who’d used it for years as he worked as an attorney in Benton Harbor/St. Joseph. But he didn’t get it new. Dan’s father-in-law purchased it from his mentor, Charles Gore. Gore was also an attorney and had purchased it new in the ‘20s or ‘30s. This was a desk where business had been conducted for close to a century!

From Before to After

I felt confident with a little TLC I could restore the desk to its former glory. The project took me about three weeks. I sanded the desk down to the original wood and put a clear coat on it. I purposely didn’t stain it because I thought the underlying natural wood was beautiful. I’m really happy with the results and hope it will bring me the same mental acuteness it brought Dan throughout his career. I see myself pulling up a chair and sitting down behind the desk, making a difference in people’s financial lives just like Dan.

How Singles Can Use File and Suspend

 There are certain advanced social security income strategies available for married couples that can help to maximize income in retirement. It’s a different story for single people who have fewer opportunities to use some of these more advanced strategies.  But there’s a strategy called “filing and suspending” that may work for you, no matter your marital status. 

File & Suspend: Not just for married couples

This strategy is sometimes used by married couples because it allows for one partner to defer taking benefits and gain credits on their benefit for doing so. In the meantime, the other partner receives a spousal benefit. But if you’re single, there is no “spousal benefit” so the rationale for utilizing such a strategy is different.  A single person might use this strategy by filing for benefits retroactively.

Retroactive Benefit Payment Limits

Under the “normal” social security rules, those who are full retirement age can only file to receive back payment benefits retroactively for up to 6 months. For example, let’s say George plans to wait until age 70 to collect benefits so he doesn’t go through the process of filing and suspending those benefits. Then, at age 67, George changes his mind and wants to file and suspend. He is only entitled to receive a lump sum payment for the last 6 months of benefits that he could have received.  If George had filed and suspended benefits at his full retirement age and later changed his mind, he would be entitled to receive all of the benefits he would have been entitled to receive going back all the way to the date that he originally filed and suspended.

When File & Suspend Can Pay Off

Now you might be asking, “Why does any of this matter if my game plan is to wait until age 70 to collect benefits?”  Your skepticism is justified because in most cases it will make no difference.  However, in some cases, your health might change from the time you are 66 to 70. Then, it would make a lot of sense to go back to social security and ask for a lump sum payment for benefits you would have received from 66 to 70.  If you filed and suspended, you are entitled to get all of those benefits. If you didn’t file and suspend than you are only entitled to receive 6 months’ worth of back payments.

The rules surrounding social security are vast and very complex.  As with any complicated financial decision, it’s often best to seek the help of a qualified financial professional to help navigate the waters.

Matthew Trujillo, CFP®, is a Certified Financial Planner™ at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.

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The information contained in this report has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making a n investment decision and does not constitute a recommendation. Any opinions are those of Center for Financial Planning, Inc. and not necessarily those of RJFS or Raymond James. Examples are for illustrative purposes only. C14-028511

Could The Dollar Lose World Reserve Currency Status?

 Clients have been asking about the potential that the U.S. could lose the role as the world reserve currency.  To really understand the issue, you need to know what a world reserve currency is and what advantages (if any) it gives the U.S. to be the world’s current leading reserve currency. 

World Reserve Currency: Protection & Stability

Almost all countries hold foreign financial reserves, whether they are in bonds or money markets, denominated in another country’s currency. In addition to this, countries will usually hold gold and special drawing rights with the International Monetary Fund. These reserves help protect a country’s currency from large swings in valuation. 

For instance, let’s say that large amounts of Japanese Yen were being sold on a global scale. The policy makers in Japan might not like the idea of their currency being depressed due to outside forces.  One strategy they might use to maintain the value of their currency is to tap into their foreign reserves (like U.S. dollars) and begin selling dollars and buying Yen.  This usually would have the effect of stabilizing the value of their local currency if they held enough U.S. dollars to make an impact on the Yen market.

Currency Liquidity

Think for a second about how many U.S. dollars the Japanese government would need to sell in order to have an impact on a global scale for the Yen.  The number is probably billions if not tens of billions of U.S. dollars. What this means is that for a reserve currency to have relevance and make sense for widespread use, it has to be very “liquid”.  Liquid means that the currency can be sold quickly and readily without having too much of an impact on the overall price.  The U.S. dollar is simply the only currency in the world currently that can make this claim. 

Alternatives to the Dollar

Some other currencies used today to bolster foreign reserves are the Euro and the British Pound/Sterling. The Euro is becoming more popular, but is still a very distant second to the U.S. dollar in terms of overall use.  In fact, recent estimates suggest that the U.S. dollar comprises 60% of foreign reserves with the Euro making up 20%.  With the recent economic troubles in Portugal, Spain, Greece, and Ireland, most experts don’t see the Euro overtaking the dollar anytime in the near future.  As far as the British Pound/Sterling goes, it would seem that the British economy is simply too small to support massive global use.  This goes back to my earlier point on liquidity.

A dark horse in reserve currency use is the Chinese Renminbi or Yuan.  The Chinese economy is certainly big enough to provide enough liquidity to global markets. However, due to tight Chinese government controls and some outright manipulation, other countries have shown hesitancy to adopt this currency on any large scale. So it would seem that the U.S. Dollar is fairly “safe” from being replaced as the world’s primary reserve currency for the time being, but why does it matter if the U.S. dollar is the world reserve currency, does it offer any competitive advantages?

Potential Advantages for U.S. Dollar as Currency Reserve

There are likely two main reasons the U.S. wants to remain as the world’s leading reserve currency. Since much of the reserves other countries hold are in the form of Treasury Bills, this has the effect of keeping a nice steady demand for bonds issued by our government.  This demand has helped to keep interest rates relatively stable over time.  Also, since the U.S. dollar is so widely accepted, American businesses do not usually need to arrange currency swaps when doing business internationally. It’s not clear what percentage this potentially adds to the bottom line for U.S. corporations, but several economists have said somewhere between 1-3%. 

There is potentially a third benefit, referred to as “seigniorage” which is the profit a country makes in the difference of issuing currency versus production costs. Experts are deeply divided on whether this is significant or has a nominal impact. For more, take a look at the Federal Reserve’s white paper on the topic. Ultimately, if the U.S. dollar is less widely used, there will be some unpleasant ripple effects, but by no means would it likely be the doomsday scenario you might have heard about from the media.

Matthew Trujillo, CFP®, is a Certified Financial Planner™ at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.

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The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Center for Financial Planning, Inc. and not necessarily those of RJFS or Raymond James. Links are being provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website’s users and/or members. C14-024135

Factoring the Cost of Living in a Post-Retirement Relocation

Your retirement plan may involve a move. You could be moving some place warm so you don’t have to put up with the wonderful Michigan winters or perhaps moving to be closer to your kids and grandkids.  Whatever the motivation, there is always a financial component in the decision-making process.

Paying for what you want vs. what you need

The cost to live in other areas of the country can be higher or lower, but some people don’t know the specific figures you will probably pay after you make the move.  Is a dollar in Michigan the same as a dollar in California or Utah? A recent conversation with a client evaluating relocating placed focus on this specific issue. His thinking was that it didn’t matter where you lived, you can always find a way to spend money.  While I certainly have to agree with him on that point, I think the bigger point is that there is a difference between spending money on things you want versus spending money on things you need.

Comparing Expenses

Let’s take a look at the cost of different goods and services in the two cities. These figures were taken from www.costofliving.org and they are an average estimate taken from people who live in Salt Lake City and San Francisco. The list of goods and services has more than 75 commonly purchased or used items but we’ll look at just a sampling of expenses.

As you can see, everything in San Fran is more expensive except the T-Bone steak. Unfortunately, after you pay for your basic living expenses, you might not have any money left over for that T-Bone! According to the living expense calculator on www.costofliving.org someone living on $70,000 of net income in Livonia, Michigan would need approximately $120,000 net in San Francisco.  In Salt Lake City, that same person would only need $69,000 to maintain the same standard of living. 

If you think a move might be in your future, talk to your financial advisor to weigh the costs associated with the new location and make sure it fits within your retirement income goal.

Matthew Trujillo, CFP®, is a Certified Financial Planner™ at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.

Any opinions are those of Center for Financial Planning, Inc. and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. C14-022592

The Power of Compounding

 

When you’re just starting in your career, you can feel strapped, earning a small salary and trying to make ends meet.  You might not feel like there is any money left over at the end of the month and that’s why some people decide to wait to start saving for retirement. However, the power that time has on your money can’t be understated.

I recently had an opportunity to meet with a long-time client’s daughter.  The goal of the meeting was to give some timely financial advice as she embarks on her new career after college. One of the key points I made was the power of compounding dollars over time.    

Using Time to Compound Money

For instance, if a 25 year old were to save approximately $4,500 a year compounding at 7% she would have close to 1 Million dollars by age 65. But, if she decided to wait to start saving for retirement until she was making more money at age 45, she would need to save $21,904 a year to accomplish the same result. That’s a staggering 486% increase in the dollars she’d need to save compared with the 25-year-old saver.

Knowing Your Benefits

To help with your retirement savings, it’s very important to fully understand your employer benefits before you begin employment.  Many employers will offer qualified retirement savings programs like a 401(k) or 403(b). If these plans exist and the company offers a match on your contributions, you should do everything you can to make sure you at least get the matching dollars.  For instance, in the case of our 25 year old, we know the potential of a $4,500 a year savings and earning 7% on that money. Now, if we factor in an employer match of $2,250, that same 25 year old would have accumulated approximately $1,350,000 over that same time horizon.

The longer you wait to start saving, the more you are going to have to put away. In other words, the pain could be much worse the later you wait.

Matthew Trujillo, CFP®, is a Certified Financial Planner™ at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.

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This is a hypothetical illustration and is provided for illustration purposes only and is not intended to reflect the actual performance of any particular security. Future performance cannot be guaranteed and investment yields will fluctuate with market conditions. C14-022060

EU Makes History by Setting Negative Interest Rates

 Some of you may have seen headlines recently regarding the European Central Bank’s (ECB) move to set interest rates on deposits from 0% to -.10%.   This is the first time in history that a major global central bank has made a move like this.  It’s important to note that this negative interest rate does not directly apply to customers of EU banks who deposit their money in savings and checking accounts.  The ECB is only applying this negative interest rate on deposits that banks make with the ECB.  In other words, the ECB is trying to penalize banks for parking large sums of money with the central bank, rather than lending it to consumers.   

Why set negative interest rates?

What is the ECB hoping to accomplish?  To answer this question I need to provide a little background on what’s been going on lately in the European economy.  The European Union (EU) has been going through a period of disinflation lately and there is much worry that it may fall into deflation. Disinflation is a slowing in the rate of inflation.  In the instance of the EU, the central bank estimates that increases in the general prices of goods and services has slowed over the last 12 months from 1.6% to .49% (as of May of 2014). If this trend continues, the ECB worries that deflation could set in, which is a general decrease in the price of goods and services.

What’s so bad about deflation?

Now this might not sound bad to many readers. After all, if the price of gas goes from $3.80 down to $2.80 that’s great, right? However, if companies aren’t making as much money on their products, they have to cut costs elsewhere in order to maintain the bottom line, and that ultimately means lower wages for workers. Which means less discretionary income to spend and the economy can get caught in a deflationary trap that can be hard to get out of.  

The hope is that setting a negative interest rate will stimulate lending and therefore growth in the economy. This could lead to slightly increasing inflation, which most experts agree is a better option over the long term than deflation. Will it work?  Experts are divided on how effective this monetary policy will ultimately be on the European economy, but like many things, only time will tell. 

Matthew Trujillo, CFP®, is a Registered Support Associate at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.

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C14-022059

How to Pick Between 3 Types of Life Insurance

 For most couples, having life insurance during the wealth-accumulating years can make a lot of sense. Also, some people may consider having a policy even in retirement, if their goal is to leave a financial legacy.  Life Insurance has a lot of potential benefits to consider such as:

• Replacement for the loss of income of a spouse
• Paying off liabilities such as a mortgage, auto loans, or credit cards
• Covering education costs for children
• Providing a lump sum for the surviving spouse to utilize in retirement
• Leaving a legacy to family or charitable organizations

When it comes to life insurance, it’s not simply deciding if you want it. It’s also deciding which kind. Here are three main types of life insurance:

Level Term Insurance

 This is the easiest type of insurance to understand because it is similar to other types of insurance you have (auto, home, disability etc.).  With Level Term Insurance you pay a premium each year and, if you die, the insurance carrier will pay a death benefit to your beneficiaries.  Typical term periods are 10, 20, or 30 years.  While you are in the level term period, your premium will remain the same.  Once your policy is outside of the level term period, the premium will begin to increase; oftentimes it will increase substantially. A few reasons where this type of insurance is appropriate:

1.  Replacing income in the event of an untimely/unexpected death
2.  Paying off liabilities
3.  Funding education goals

Universal Life Insurance

This is sometimes referred to as “permanent term insurance”.  This product is usually underwritten to make sure a death benefit remains in place until age 90, 95, or 100.  Sometimes there is a cash value in the earlier years of the policy, but this is usually eaten up by internal costs and expenses as the policy reaches maturity.  This product is often used when someone wants to leave a financial legacy to their kids, church, or charity. Also, it can be used to ensure alimony or other similar court settlement agreements are paid, even in the event of an unexpected death.

Whole Life Insurance

This type of insurance is conservatively underwritten, and because of this, it is often the most expensive type of insurance.  It does have a cash component that takes several years to begin accruing.  A lot of the products I have seen take approximately 10 years to break even from what you have paid in premiums compared to what’s available in cash value.  This is another type of permanent insurance that is frequently used in legacy planning.  When Estate Taxes were an issue for many Americans (back when the exclusion amount was $3.5 Million or less) these policies were purchased to provide liquidity to pay Uncle Sam at death.

What is the right type of insurance for you? 

We typically recommend Level Term Insurance for clients when the primary goal is income replacement during the wealth-accumulation years. It’s the most affordable, and usually isn’t a significant burden on cash flow.  However, if your goal is to leave a financial legacy, and you can afford it, then Universal Life or even a Whole Life policy might make sense.

The best strategy, when making these decisions, is to work with a qualified financial professional that understands all the moving parts of your personal situation and is making a recommendation that is in your best interest.

Matthew Trujillo, CFP®, is a Registered Support Associate at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.

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The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Center for Financial Planning Inc. and not necessarily those of RJFS or Raymond James. Investments mentioned may not be suitable for all investors. These policies have exclusions and/or limitations. The cost and availability of life insurance depend on factors such as age, health and type and amount of insurance purchased. Policies commonly have mortality and expense charges. In addition if a policy is surrendered prematurely, there may be surrender charges and income tax implications. Guarantees are based on the claims paying ability of the insurance company. C14-019165

Paying for College at Your Expense

We all want the best for our children.  In an ideal world, if we could pay for 100% of their college and allow them to graduate with no student debt, most parents would gladly do it. However, anytime you use cash flow to pay for college there is an opportunity cost.  “What else could I have done with that money if I had not used it to pay for my kid’s college?”  The simple answer is that you could be using that money now to put toward your retirement.  You can take loans for college, but you can’t take a loan for retirement.

Opportunity Cost of College Tuition

For some of you reading this, opportunity cost might seem like a foreign idea or an abstract concept that can’t be measured.  However, it is very real and although it can’t be measured to the exact penny, you can make some educated estimates about the potential growth of your savings.

For illustrative purposes, let’s take a look at a hypothetical scenario and measure the potential opportunity cost of paying for college.     

Scenario: John and Jane Smith (both age 35) have 1 son Joe Smith and intend to fully fund 4 years of undergraduate school for Joe.  Their son was born in December of 2013. John and Jane are both U of M graduates and, assuming Joe is as bright as mom and dad, they would like him to go there as well.   In any case they intend to pay for 4 years of U of M starting in 2031. The Smiths consider these costs:

• The cost of U of M for tuition, room, and board is approximately $20,000 in today’s dollars and is estimated to inflate at 6% annually over the next 18 years.

• So the Smith’s estimate the first year of college will cost $57,086, 2nd year $60,511, 3rd year $64,142, and 4th year $67,991. 

• The total estimated cost for 4 years of college is $249,730.

Adding Up the Opportunity Cost

Unfortunately, the cost doesn’t end there.  This is where the concept of opportunity costs comes in. You see, the Smiths didn’t have to set aside these funds for Joe. They could have put them in their retirement accounts instead.  To fully understand the true cost of utilizing those dollars to pay for education, you also have to measure what that money could have potentially grown to at John and Jane’s retirement age of 65.  When Joe starts college John and Jane would be 53.  That means the $249,730 they have set aside could have the opportunity to grow for another 12 years. Assuming a 6% rate of growth the hypothetical account would compound to $502,505.   John and Jane would have the opportunity to add an additional $250,000 to their retirement account.

Having said all of this I’m not advocating kicking the kids out at 18 and changing the locks.  However, I am advocating being informed about the ripple effects of the financial decisions we make.  For people under the age of 40 with no pensions (and social security looking like a shaky proposition) it is imperative that you be efficient with financial decisions.  One of the benefits of working with a professional planner is putting these decisions under a microscope and creating a plan to decide what you can truly afford to do while still maintaining your financial independence.  

Matthew Trujillo, CFP®, is a Registered Support Associate at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.

Any opinions are those of Center for Financial Planning, Inc. and not necessarily those of RJFS or Raymond James. All illustrations are hypothetical and are not intended to reflect the actual performance of any particular security. Future performance cannot be guaranteed and investment yields will fluctuate with market conditions. Investing involves risk and investors may incur a profit or a loss. C14-017739

Roth vs. Traditional IRA

 If you’re planning to use an IRA to save for retirement, but aren’t sure if Roth or Traditional is best for you, we can help sort it out. First, before we begin breaking down the pros and cons of each type of retirement account, you need to be sure that you are eligible to make contributions to these accounts.

For 2014 Roth IRA contribution rules/limits:

• For single filers the modified adjusted gross income (MAGI) is phased out between $114,000 and $129,000 (unsure what MAGI is? Click here)
• For married filing jointly the MAGI is phased out between $181,000 and $191,000
• Please keep in mind that for making contributions to this type of account it makes no difference if you are covered by a qualified plan at work (such as a 401k or 403b), you simply have to be under the income thresholds.
• Maximum contribution amount is $5,500

For 2014 Traditional IRA contributions:

• For single filers who are covered by a company retirement plan (401k, 403b etc…), in 2014 the deduction is phased out between $60,000 and $70,000 of modified adjusted gross income (MAGI).
• For married filers, if you are covered by a company retirement plan in 2014, the deduction is phased out between $96,000 and $116,000 of MAGI.
• For married filers not covered by a company plan but with a spouse who is, in 2014 the deduction for your IRA contribution is phased out between $181,000 and $191,000 of MAGI.
• Maximum contribution amount is $5,500

If you are eligible, you may be wondering which makes more sense for you?  Well, like many questions in finance the answer is…it depends! 

Roth IRA Advantage

The benefit of a Roth IRA is that the money grows tax deferred and someday, when you are over age 59.5, you can take the money out tax free.  However, in exchange for the ability to take the money out tax free, you don’t get an upfront tax deduction from the IRS.  Essentially you are paying your tax bill today rather than in the future. 

Traditional IRA Advantage

With a Traditional IRA, you get an upfront tax deduction.  For example, if a married couple filing jointly had a MAGI of $180,000, (just below the phaseout threshold), then they would probably be in a 28% marginal tax bracket.   If they made a full $5,500 Traditional IRA contribution they would save $1,540 in taxes.  To make that same $5,500 contribution to a ROTH, they would need to earn $7,040, pay the taxes, and then make the $5,500 contribution.  The drawback of the traditional IRA is that you will be taxed on it someday when you begin making withdrawals in retirement.

Pay Now or Pay Later?

The challenging part about choosing which account is right for you is that nobody has any idea what tax rates will be in the future.  If you choose to pay your tax bill now (Roth IRA), and in retirement you find yourself in a lower tax bracket, then you may have been better off going the Traditional IRA route. However, if you decide to make Traditional IRA contributions for the tax break now, and in retirement you find yourself in a higher tax bracket, then you may have been better off going with a Roth. 

How Do You Decide?

A lot of it depends on your personal situation, such as the career path you’ve chosen and your desired income in retirement. However, we typically recommend that people just starting out in their careers who will probably earn a much higher income in the future make ROTH contributions.  If you’re in the 25-28% marginal bracket, a Traditional IRA may make more sense for the immediate tax break now.  As always, before making any final decisions, it’s always a good idea to work with a qualified financial professional to help you understand what makes the most sense for you.

Matthew Trujillo, CFP®, is a Registered Support Associate at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.

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This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the Center for Financial Planning, Inc. and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Roth IRA owners must be 59 ½ or older and have held the IRA for five years before tax-free withdrawals are permitted. You should discuss any tax matters with the appropriate professional.

Links are being provided for informational purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website’s users and/or members. C14-015057

What should I do with bonds if interest rates go up?

 Lately the bond markets have been making headlines.  It’s no secret that we, as a country, are in a historically low interest rate environment and, as a result, a lot of so-called “experts” are talking about rising interest rates in the near future.  These experts usually go on to state that if interest rates begin to rise and you have bonds you could face substantial losses.  Unfortunately, like many things in finance, this type of blanket statement is misleading because not all bonds are created equal! 

Traditional Bonds

First, let’s dissect their argument to understand why an investor might lose money in a rising interest rate environment. Bonds are typically issued by a government, a municipality, or a corporation.  These entities need money for a variety of purposes and one way they can get that money is by taking a loan from investors.   In exchange for an investor loaning that money to these entities, there is a promise to pay back the original loan amount (principal) as well as an interest rate paid on that principal over the life of the loan.  The challenge and the risk to current bond investors is that if interest rates begin to rise, the traditional bonds they hold might not look as attractive to new potential investors.  If you think about it, why would I, as a new potential investor, want your bond paying an interest rate of 3.5% when I can buy a new bond from the same company (or government/municipality) paying 4.5% today?  Assuming all else is equal except the rate of interest, then I think the answer is pretty clear. It would be silly for me to purchase a bond paying 1% less. 

So how does the bond holder with the unwanted 3.5% bond get rid of it?  The answer is he has to sell it at a reduced price.  This reduction in price is the big risk that experts keep referring to.  It’s important for investors to remember that if you hold individual bonds you will get your principal back at maturity as long as the company stays in business and doesn’t default.  Regardless of what your statement says the bond is worth at any given time, that value or number only applies if you choose to liquidate the bond at that exact point in time.  

Hopefully, this very simplistic example helps you understand the inherent risks involved with more “traditional” bonds and a rising interest rate environment.  As I said, not all bonds are created equal, and some types will probably benefit from a rising interest rate environment. 

Floating Rate Bonds

It’s probably clear by now that the biggest issue, in a rising interest rate environment, is the fixed rate of interest that “traditional” bonds pay.  If rates started to rise, and the interest rate on your bond rose along with it, then you probably wouldn’t have to discount your bond much, if at all. 

So are there bonds out there that can rise as overall market rates rise?  Yes! They are called floating rate bonds.  A floating rate bond typically “resets” its interest rate annually, although some will reset more frequently.   Because of this “reset” floating rate bonds can be a very attractive investment option when overall interest rates are projected to rise in the near term.  Please keep in mind that floating rate bonds aren’t without risk of loss…the point is just that they typically maintain their secondary market value even when interest rates rise.

Now that you have read this, the next time you see the headlines that claim bonds are bad and to avoid them like the plague, you should have a good sense of what type of bonds they are referring to.  Also, know that it is still possible to make money in bonds in a rising interest rate environment!  Floating rate bonds may or may not be suitable for your portfolio.  In order to make that determination you would need to perform a total portfolio analysis in coordination with your financial professional.

Matthew Trujillo, CFP®, is a Registered Support Associate at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.

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As with any fixed income investment, there is a risk that the issuer of a floating rate investment will be unable to meet its payment obligations. In addition to the risk, floating rate bonds also face the following risks:

Reference rate risk: While the market value of a floating rate bond under normal circumstances is relatively insensitive to changes in interest rates, the income received is, of course, highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate or reference rate expectations are not met. It is also important to note that since short-term rates are usually lower than long-term rates, the initial coupon of a floating rate bond is typically lower than that of a fixed-rate bond of the same maturity.

Call risk: A floating rate bond may be issued as either non-callable or callable. If a callable floating rate bond is called by the issuer prior to maturity, the investor may be unable to reinvest funds in another floating rate bond with comparable terms. If the floating rate bond is not called, the investor should be prepared to hold it until maturity.

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Center for Financial Planning Inc. and not necessarily those of RJFS or Raymond James. C14-013999