Reader Q&A – 7/31/13

Here are some questions asked recently by readers. Today’s Q&A deals with the topics of defined maturity bond funds, dividend reinvestment strategy, saving for a million dollars and calculating a company’s current ratio.

 

But first, a few words:

 

Fine print: I am not your financial advisor. I typically avoid questions that are unique to an individual (e.g, “should I buy this fund/stock/bond or this fund/stock/bond?”) However, other questions that are more general and have a straightforward answer, I feel that I can answer without knowing your whole financial picture. An asset manager would take hours talking with a client before answering many types of investment questions, so I don’t feel qualified to answer too many individual specific questions. No investment decisions should be made based on the answers to these questions.

 

Have a question? Leave it in a comment below any post, or email me at matt@begintoinvest.com

 

Now lets get into the questions…

 

  • Can Guggenheim BulletShares defined maturity funds lose me money if I hold until maturity?

First, if you are unfamiliar with the defined maturity fund, see our ETF spotlight series article where we discussed these funds here:

https://www.begintoinvest.com/fund-spotlight-series-defined-maturity-funds/

 

Answer: Yes.

 

I believe the misconception comes from the idea that if you buy a bond at par value and you hold until maturity, you will receive your principal back. No matter what interest rates do in between the date of purchase and maturity, if you buy a bond at par for $1,000, you will get $1,000 back when the bond matures.

 

So, since Guggenheim’s funds buy bonds and hold them until maturity, do investors in the fund risk losing money?

 

Consider what happens if you buy that bond above par value. Let’s say a 10 year bond has an interest rate of 3% and a par value of $1,000. If interest rates fall (say to 2%), investors will be willing to pay more for a bond yielding 3%, because new bonds have lower yields. This will cause the bond’s price to rise. In this case to about $1,090.

Now, an investor who buys that bond on the secondary market for $1,090 does not get $1,090 back at the time the bond matures, he only gets the par value, which is $1,000. Depending on how much the investor received in interest payments over the course of the bond, it would be possible that the investor actually lost money. This would not happen on a long term bond described above, however during the height of the 2008 financial crisis short term government bonds actually had a negative yield because investors were paying so much to have their money in a “safe” investment. Investors guaranteed themselves a loss because they were so scared about where to safely put their money.

 

Investors in Guggenheim’s BulletShares defined maturity funds are not guaranteed to get their initial investment back, partially because the bonds that make up the fund may be purchased well above par, partially because of fees the fund takes in and partially because Guggenheim may pay out more money in dividends than what they receive from interest payments on the bonds that make up the fund. This is detailed in the fund’s prospectus:

 

Fluctuation of Yield and Liquidation Amount Risk.

The Fund, unlike a direct investment in a bond that has a level coupon payment and a fixed payment at maturity, will make distributions of income that vary over time. Unlike a direct investment in bonds, the breakdown of returns between Fund distributions and liquidation proceeds are not predictable at the time of your investment. For example, at times during the Fund’s existence, it may make distributions at a greater (or lesser) rate than the coupon payments received on the Fund’s portfolio, which will result in the Fund returning a lesser (or greater) a mount on liquidation than would otherwise be the case. The rate of Fund distribution payments may adversely affect the tax characterization of your returns from an investment in the Fund relative to a direct investment in corporate bonds. If the amount you receive as liquidation proceeds upon the Fund’s termination is higher or lower than your cost basis, you may experience a gain or loss for tax purposes.”

 

 

So yes, you can lose money even with holding these funds to maturity.

 

  • Should I reinvest my dividends monthly or quarterly?

 

The answer to this question depends on several factors, and will vary based on the investor, but here is how you can figure out which is best for you:

 

In a world without brokerage commissions, reinvesting your dividends as soon as you receive them is best. When your dividends just sit as cash in your brokerage account, they earn you nothing. You want to put them to work right away to buy you more shares which will hopefully appreciate in value and pay more future dividends. Therefore by that logic, monthly reinvesting would be better than quarterly.

 

However, we don’t live in that perfect world (but we are close, more below on commission free ETFs)

 

Consider the typical brokerage which charges a $7-$15 commission for each purchase.

For an example, let’s say you get $10 in dividends each month and you want to buy a stock that is $10 per share. Although technically your dividend allows you to purchase an additional share, if you pay $15 in commissions to reinvest those dividends, it ends up costing you more than the dividend just to reinvest!

For an investor in this situation, you may want to hold a few months of dividends to avoid paying a commission each month.

 

However, this is where the beauty of commission free ETFs comes in. Many brokers offer commission free funds that would allow you to reinvest dividends for no charge.

 

(See the complete list here: https://www.begintoinvest.com/broker-comparison-commission-free-etfs/ –  where we compare the commission free offerings by the brokers)

 

For an investor using these commission free funds, reinvesting your dividends as soon as possible is preferred.

 

Many mutual funds offer commission free dividend reinvestments as well, and if you are with a broker that does not offer commission free ETFs, you may want to look into mutual funds that would allow you to do that instead.

 

 

Just for an example, I took the last 2 years’ worth of share price and dividend data on the bond ETF: BND (Vanguard Total Bond Fund).

 

Lets see what the difference between reinvesting dividends monthly compared to quarterly would be:

 

Monthly vs quarterly dividend reinvestment

 

Reinvesting dividends monthly results in about $45 more for $10,000 invested after just 2 years ($10,315.76 vs $10,271.12). This out-performance would be more evident over longer time frames and with more principal invested. Over the course of your investing lifetime, the result could well be in the thousands of dollars difference.

However, note that the $45 would be easily eaten away by commissions if you had to pay commission each month to make those purchases. So, if you are investing in a commission free fund, monthly dividend reinvestment is the way to go. If not, you have to consider how the commissions eat into your returns and invest accordingly.

 

 

  • I am 25 years old, how much money do I need to save to have a million dollars by the time I retire?

 

Although this question can not be answered with certainty because there is no guarantee what the future returns will be on your savings, we can make a few guesses based on historical market data.

In our post “Saving for a Million Dollars”   we detail how much money an investor at every age would have to save each year (assuming a 7% return) to have a million dollars at age 65.

 

At age 25, you would have to save $5,009 per year (or $417 per month), while returning 7% a year, to reach a million dollars at age 65.

 

Just for a fun fact – just waiting 5 additional years to start saving and investing (age 30) means having to save $7,233 per year or $602 per month to achieve the same result. So get started early!

 

Great job on being concerned about this at age 25. Get started now and you can be well on your way to a million!

 

 

  • Are deferred taxes used in calculating a company’s current ratio?

 

 

If you are unfamiliar with the current ratio, see the current ratio definition page: https://www.begintoinvest.com/definitions/current-ratio/

 

Answer: Yes, but…

Strictly going by the definition of the current ratio, you would use all current assets listed on the company’s balance sheet.

 

However, it is obvious why this answer would trouble an analyst. Money set aside by a company to pay for a future tax obligation is not going to be used to help pay to run the business, so why is it included?

 

Because of this, many investors prefer to use the more conservative quick ratio, which removes current assets like deferred taxes, prepaid expenses and restricted cash that are not going to be used to help fund the company’s operations.

 

 

 

 

That’s all we have for now, keep the questions coming!

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