Friday, February 28, 2014

How to Calculate Tax-Equivalent Yield for a Series 7 Question

When an investor has found two 10-year bonds, both rated A-, should she invest in the 6% tax-free municipal bond or the 8% taxable corporate bond?
The answer depends entirely on her marginal tax rate. A test question could go something like this . . .

When deciding between a 6% tax-free bond and an 8% taxable bond, at which marginal bracket does an investment in the tax-free bond become advantageous?
A. 20%
B. 25%
C. 30%
D. 33%

In order to figure out the tax rate that first makes the 6% bond more attractive, you''ll have to keep taking the .06 the bond pays and divide it by .80, then, .75, then .70, and maybe even .67 until the tax-equivalent yield ends up higher than 8%. What happens when we take .06 divided by .75? We get a tax-equivalent yield of .08, which is exactly the same as what the corporate bond offers. Not surprisingly, when we take .06 and divide it by .70 (30% marginal bracket), we find that the tax-equivalent yield is now 8.57%, making C our answer. Yes, at 33% the investor should also be buying the municipal bond, but the question asked at which bracket the yield begins to rise above 8%. As always, the Series 7 expects you to do more than memorize a few terms and try a few little tricks to fudge your way through it.Pass your Series 7

Monday, February 17, 2014

The Often Overlooked Unit Investment Trust

Most Exchange-Traded Funds (ETFs) are set up as unit investment trusts that are only redeemable into large "creation units" by the broker-dealers who sponsor them. Everyone else trades the shares, which seek to mimic the performance of a particular index. That's all well and good, but the UIT that intrigues me is the fixed portfolio of preferred stock or bonds that has no investment adviser and, therefore, no management fee. A portfolio of, say, 50 preferred stock issues is purchased and placed in trust overseen by the trustee, who pays out the income produced by the securities in the portfolio after trustee and administrative fees have been deducted. Your exam might refer to such a UIT as a "supervised, non-managed portfolio, typically of fixed-income securities." That's exactly what it is, and since I'm pretty sure that trading in and out of preferred stocks is both expensive and unnecessary, I see no reason to pay an investment adviser to manage/trade the portfolio.
So, what's stopping me? Interest rates. Yields are still so low at this point that I can't get excited over parting with a large chunk of change just to watch 2-3% yields dribble in. I've told myself that when I can get a 5% yield or higher, I will start buying in. As your test wants you to know, my risk is that interest rates will keep climbing after I buy in--the value of my units will drop if that happens. Then again, I would still be collecting a decent yield from preferred stock, and I can check the credit quality of the issues and let the trustee handle it from there.
A likely test question on a UIT would point out that these securities are primarily regulated under the Investment Company Act of 1940.Need Help with your Series 7?