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December 1, 2003

Convertible Bonds - Part Bond, Part Stock

Convertible bonds are a hybrid investment, combining features of both stocks and bonds. Like all bonds, convertibles pay a fixed interest rate for the bond's life, with the principal returned at the end of the bond's term. However, convertible bonds can also be exchanged for a specific number of shares of the issuing company's common stock.

The bond's interest payments are typically higher than the dividends paid on the common stock, although the interest rate is usually lower than that on nonconvertible bonds. However, the ability to convert to common shares allows investors to participate in share price increases without as much exposure to share price decreases. Convertibles do not decline as much as the common shares because the bond retains a market value equal to comparable bonds paying the same yield, which acts as a floor for the convertible's value.

When issued, the convertible bond's value exceeds the common stock's price by an amount known as the conversion premium, which changes as the stock price changes. If the stock is selling below the conversion equivalent, there is no financial incentive to convert the bond, so its price will be primarily determined by factors affecting bonds. Once the stock's price rises enough to provide a profit by converting the bond, the stock's value will significantly affect the convertible's market value.

Most convertibles can be called back by the issuer at a specific price. These call provisions are typically used by the issuer to force investors to convert the bond to common stock so the debt obligation can be eliminated.

Since they are a hybrid investment, convertible bonds can be difficult investments to evaluate. You should only invest in a convertible if you like the underlying stock. Consider bond and stock pricing, current interest rates, the probability of a bond call, the convertible's yield advantage over common stock, the convertible's fixed-income value, and the volatility of the underlying stock.

Don't Let Heirs Make These Mistakes

While annual contributions to IRAs are still relatively modest, the ability to roll over 401(k) balances to an IRA can result in significant IRA balances for many investors. Thus, in addition to retirement planning vehicles, IRAs are becoming estate planning tools for investors who don't use the entire balance during their lifetimes. If you are in that situation, make sure your heirs know how to avoid some common IRA mistakes:
  • Using the IRA balance too quickly. After an IRA is inherited, a traditional deductible IRA still retains its tax-deferred growth and a Roth IRA retains its potentially tax-free growth. Your beneficiaries' goal should be to extend this growth for as long as possible. If the IRA has a designated beneficiary, which includes individuals and certain trusts, then the balance can be paid out over the beneficiary's life expectancy. Spouses have additional options which can stretch payments even longer. Your heirs can also elect to take the entire balance immediately, paying any income taxes due. Make sure to stress to heirs the importance of taking withdrawals as slowly as possible.

  • Not splitting the IRA when there are multiple beneficiaries. When there are multiple beneficiaries, you can split the IRA into separate accounts by December 31 of the year following the original owner's death. If the account is not split, distributions must be taken by all beneficiaries over the life expectancy of the oldest beneficiary. By splitting the IRA into separate accounts, each beneficiary can take distributions over his/her life expectancy. This is especially important to a surviving spouse, who can only roll over the IRA to his/her own account if he/she is the sole beneficiary. With the rollover IRA, the surviving spouse can name his/her own beneficiary, thus extending the IRA's life, and can defer payouts until age 70 1/2. When other than an individual or qualifying trust is one of the beneficiaries, the IRA must be distributed within five years when the owner dies before required distributions begin or over the owner's life expectancy when the owner dies after required distributions begin. Separating the account or paying out the non-individual's portion then allows the individual beneficiary to take distributions over his/her life expectancy.

  • Rolling the balance over to a spouse's IRA too quickly. Once a spouse rolls over the balance to his/her own IRA, some planning opportunities are eliminated. While the IRA balance can typically be spread out over a longer period when the balance is rolled over, the spouse may need distributions. For instance, spouses under age 59 1/2 may make withdrawals from the original IRA without paying the 10% federal income tax penalty. Once the account is rolled over, withdrawals before age 59 1/2 would result in a 10% federal income tax penalty. Also, spouses who are older than the original owner can delay distributions by retaining the original IRA. The surviving spouse does not have to take distributions until the deceased spouse would have attained age 70 1/2, even if the surviving spouse is past that age. The spouse may want to disclaim a portion of the IRA, which must be done within nine months of the original owner's death. If the account is rolled over, that disclaimer can't be made. Thus, it is usually best for the surviving spouse to determine his/her financial needs before rolling over the IRA balance.

  • Not properly establishing the inherited IRA. An inherited IRA must be retitled to include the decedent's name, the words "individual retirement account," and the beneficiary's name. The IRA cannot simply remain in the decedent's name.

Managing Your Home Investment

Housing prices have been the one bright spot in the economy over the past couple of years. While stock prices have headed down and interest rates have been on the decrease, home prices have steadily moved up. No one knows where home prices will head in the future. But for many individuals, their homes will continue to be their largest asset and a major contributor to building net worth. Your home is an investment, so you should develop strategies to manage that investment well. Some points to consider include:
  • Don't stretch to purchase the largest home you can. The reason homes have contributed so significantly to many people's net worth is that you retain any price appreciation on the entire home, even though you only put down 10-20% of the purchase price. That fact has caused many people to strain their budgets and purchase the largest home they can afford, hoping the increase in the home's price will more than offset the sacrifices made along the way. Before embarking on such a strategy, be aware of all the risks. If home prices start to fall, you could end up owing more than you can sell the home for. Also, should you lose your job or your income declines, you may have difficulty paying the mortgage and other housing costs. If your budget is strained to the limit, you might not have money left over to contribute to your 401(k) plan or individual retirement account. It may be a better strategy to purchase a home you can comfortably afford.

  • Don't take equity out of your home in the form of a home-equity loan or a higher mortgage balance. While lower interest rates allowed many homeowners to reduce their monthly mortgage payments, many also opted to take equity out of their homes and to stretch mortgage payments over longer periods. One of the main advantages of home ownership is that it's a forced savings plan, with part of every mortgage payment going toward equity. Resist the urge to take that equity and spend it on something else.

  • Make sure you have adequate insurance. Your homeowners insurance policy should be sufficient to completely rebuild and refurnish your home in the event of a total disaster. Check the limits of your policy every year and increase those limits if needed. You will probably want a guaranteed replacement clause, which pays the entire cost of rebuilding your home.

  • Inventory everything in your home. You can either write or videotape the inventory. Include everything in your home, systematically working your way around every room so nothing is left out. Keep receipts for the larger items with the inventory. The inventory and receipts will help substantiate a claim should your home and its contents be destroyed.

Evaluating Your Personal Financial Situation

As we approach the start of a new year, it is a good time to evaluate your financial situation to determine if you are making progress toward your financial goals. To make this evaluation, prepare a net worth statement and analyze how your income is spent.

Net Worth Statement

A net worth statement lists all your assets and liabilities, with the excess representing your net worth. All assets should be included, such as vested balances in retirement plans and 401(k) plans, personal property, jewelry, and household items. Assets should be valued at the price you would obtain if you sold them now, not the amount you paid for them. Prepare a net worth statement at least annually so you can assess how much progress you made during the year. Ask yourself the following questions when reviewing the statement:

  • Has your net worth grown by more than the inflation rate? To make progress toward achieving your financial goals, your net worth should increase by more than the inflation rate. If your net worth is not growing, determine why. If stock investments are a major portion of your assets, then your net worth may have actually decreased depending on how the market performed.

  • What is your ratio of assets to liabilities? A ratio of less than one indicates you have more liabilities than assets and a negative net worth. If that is the case, take active steps to reduce your liabilities. This ratio should increase over time, which indicates you are reducing debts.

  • What is the trend in your liabilities? Review the amounts and types of debt you have. Mortgages are typically used to purchase items appreciating in value and are generally considered "good" debt. Credit card balances and auto loans are used to finance items that typically don't appreciate in value, and should be kept to a minimum.

  • What percentages of your assets are liquid and nonliquid? Nonliquid assets include items like your home, other real estate, jewelry, and works of art. Although they may increase in value over time, they can be difficult to sell quickly at full market value. Liquid assets, such as bank accounts and stocks, are more easily converted to cash. You want sufficient liquid assets to cover financial emergencies.

  • How have your investments performed? Now may also be a good time to thoroughly analyze your portfolio's performance over the past year. Measure the performance of each investment, comparing it to an appropriate benchmark. This can help you identify portions of your portfolio that may need to be changed. Also calculate your overall rate of return and compare it to your targeted return. If your actual return is lower than the return you targeted when designing your investment program, you may need to increase your savings, select more aggressive investments, or settle for less money in the future.

Spending Analysis

Even if you don't feel the need for a budget, analyze how you spend your income. This analysis can help you identify ways to reduce spending so you can increase savings.

First, prepare a cash flow statement that details your income for the past year and your expenditures by category, which will reveal your current spending patterns. Looking back over an annual period will help you identify normal monthly expenses as well as periodic expenses, such as insurance premiums, tuition, and gifts. Canceled checks, credit card receipts, and tax returns can provide much of the needed information. However, you might want to keep a journal of all expenditures for a month or so if you are unable to account for large sums of money.

Divide the expenditures among fixed and essential expenses (housing, insurance, taxes, saving, etc.), variable and essential expenses (food, medical care, utilities, etc.), and discretionary expenses (entertainment, clothing, travel, charitable contributions, etc.). Analyze the statement to find items you can cut back on, allocating those sums to savings.

Your budget should incorporate your financial goals and serve as a guide for your future spending. Some points to consider when preparing a budget include:

  • Make conscious spending decisions. Don't just assume you'll spend the same amounts as last year.

  • Prepare a flexible budget. Unexpected expenditures are bound to happen and your budget should incorporate the possibility of that happening.

  • Budget for large, periodic expenditures, such as tuition or insurance premiums.

  • Don't try to be too exact. All members of the family should have a reasonable personal allowance that can be spent without accounting for it.

  • Periodically compare your actual expenditures to your budget to ensure you stay on track.

  • Your budget shouldn't be a dreaded exercise, but a tool to help you achieve your financial goals. So keep it short, simple, and easy to implement.

These two tools can help you evaluate where you currently stand financially. Prepared annually, they can also help you assess your progress and keep you on track toward achieving your financial goals.

Resolving For A Better Financial Year

As a new year approaches, resolve to start working on accomplishing your financial goals. If you can't count on a rapidly advancing stock market to help achieve your goals, what strategies should you use? Consider the following:
  • Save until it hurts. The ultimate value of your investments is a result of the amount you save and your rate of return. With rates of return down, you should seriously consider increasing your savings. Even modest increases in the amount you save can dramatically increase your investment values over the long term. Having trouble finding money left over to save? Find ways to make saving automatic. Increase your 401(k) contributions or have money automatically withdrawn from your checking account every month and deposited directly in an investment account. Start out with small amounts if you need to, increasing the amount periodically.

  • Downsize your lifestyle. It's a basic fact that most people have trouble coming to grips with -- the amount of money you have left over for savings is a direct result of your lifestyle. Don't have money to save? Reduce your living expenses. Be ruthless when cutting expenses -- dine out less, stay home rather than going away for vacation, rent a movie rather than going to a theater, cut out morning stops for coffee and a muffin. Redirect all those reductions to your savings. And don't just look for painful ways to save money. When was the last time you comparison shopped for auto or homeowners insurance? Have you looked for credit cards with lower interest rates? How about keeping your car for another year or two instead of buying a new one? Reducing your lifestyle now will have a two-fold impact -- it will allow you to find more money to save and it will likely reduce your expenses after retirement. Get used to a downsized style of living now and you'll be comfortable with a similar lifestyle after retirement.

  • Pay down debt. Any money going to pay interest on loans is money you can't save. Try to eliminate all your debts except your mortgage. Start by resolving not to incur any additional debt. If you have trouble controlling credit card spending, put the cards away and only use cash for purchases. With existing debt, come up with a plan for paying the debts off. Rather than paying a little bit extra on all your debts, pay off the debt with the highest interest rate. Once that debt is paid in full, start paying down the debt with the next highest interest rate, continuing until all your debt is paid in full.

  • Don't avoid the stock market. Everyone is a little apprehensive of the stock market after recent declines. But that's no reason to avoid the stock market totally. Although stocks go through up and down periods, over the long term their returns have been higher than other types of investments. So don't avoid the stock market, just approach it with caution. Investigate carefully before purchasing stocks and use stocks as only one portion of a diversified approach to your portfolio management.

  • Reevaluate your financial goals. Can you still afford to send your children to Ivy League colleges? Is it realistic to expect to retire before age 65? Once you retire, can you afford to travel extensively or take on expensive hobbies? Can you retire totally or should you plan on working at least part time? Carefully assess your goals, decide what you can really afford to accomplish, and make a plan to achieve those goals. You're likely to find those goals are drastically different than goals you set a few years ago.


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