To Sell, or Not to Sell, a Falling Junk Bond Fund
Q: Several years ago I invested $25,000 in a high-yield income fund. Over the last several months, the value of my investment has shrunk to about $16,000, and my monthly interest payment, once $220, has fallen. What should I do: take my losses and get out now--or hang in there, hoping that things will get better? I made the investment primarily for monthly income, so if that starts to drop, as well as my principal, I’m really going to be hurting. --C.M.F
A: A question such as this is bound to set off a flurry of conflicting advice, so accept this not so much as gospel but as just another opinion from an informed, but nevertheless human, source.
Our financial planning experts suggest that you stand pat for the time being--not only out of hope that things will improve, but because the interest rate of your fund, relative to its current price, is high enough now that it should lure new investors. This, in turn, should drive up its value. Furthermore, what would you do with the proceeds of the sale? In today’s environment of falling rates, can you match the return you are getting now, even after the yield has dropped?
Your high-yield fund has dropped in value because it is no doubt comprised almost entirely of junk bonds. (Investors, take note: high yield is often another term for junk bonds.) The collapse of Drexel Burnham Lambert, the Wall Street brokerage that popularized junk bonds, the default of several junk bond issues earlier this year and recession fears have all combined to undermine the value of most, if not all, high-yield investment funds.
But this does not mean that all high-yield funds are disastrous investments. Hardly. All junk bonds were not created equal; some are far better than others. And a goodly number are no more likely to go into default than the bonds of the bluest of Wall Street’s blue chip companies. Meanwhile, these bonds continue to pay yields substantially above market rates. Still, their market value is driven by external forces that you have little control over. But unless you want to sell, you moves don’t have to be influenced entirely by your fund’s fluctuating value.
However, you do mention that your fund’s yield has dropped, a disappointing and potentially scary development. This means that obviously some bonds in the fund have defaulted and the bond holders are not being paid. But, nevertheless, calculate your current return on your original investment and try to determine whether you can find a similar yield. It’s probably doubtful.
By sitting on your investment for awhile you not only are doing as well--if not better--than the current market. You are betting that the market for your fund will improve. But if you just can’t stand the uncertainity or don’t like gambling--unlikely given your original investment in a junk bond fund--you still can cut your losses and get out.
Bonds Aren’t Best Way to Help Budding M.D.
Q: I understand that, beginning this year, I can purchase U.S. Savings Bonds for my son’s education, tax free. He is now attending medical school and has taken out many loans to finance his education. I want to help him repay these loans. Are the bonds the best way to do this? Do you have any other alternatives? -- S.S.
A: The new U.S. college savings bonds are not the answer for you. For starters, the beneficiaries of the bonds must be under age 24. If your son is in medical school now, by the time the bonds mature, he will be over the age limit.
These bonds are best suited to middle-income families whose children are still in grammar schools because the tax breaks are gradually phased out once a family’s adjusted gross income exceeds $60,000 and because the bonds need a minimum of 12 years to mature.
Why don’t you simply give your son money to pay off his medical school loans? Remember, you may give your son $10,000 every year without paying gift tax. Depending on the interest rates on his loans, he can use your gift to repay the loans at once or invest your gift in a tax-sheltered account and let it grow while he slowly pays down his debts.
Swelling IRA Accounts May Cause Estate Woes
Q: I have $150,000 in individual retirement accounts, and when I turn age 70 1/2 next year, I will withdraw about $7,280. This is about 5% of the accounts’ total. But I am earning about 9%, so at the end of the year, I will have more than when I started, even after the mandatory distribution. The next year, the situation will be the same. The way I figure it, I will never deplete the account! Is this true? What should I do about it?
A: You’re absolutely right that your account will get larger--not smaller!--for many years after you begin withdrawals. In fact, according to our financial experts, if you continue taking just the minimum required annual withdrawal, your account balance won’t begin shrinking for 15 years after distributions begin. At that point--you’ll be about 85 years old--your account will begin to drop.
However, is this what you want? Is it good financial planning? Possibly not, says Torrance financial planner Thomas Gau. Gau says there are potentially severe estate tax implications to maintaining such a high balance in an IRA, especially at your age.
Because IRAs contain funds that have not yet been taxed by the government, they can be hit with a huge income tax bite after your death. Making a revocable living trust the secondary beneficiary of your IRA--after your spouse--is a potential solution. Your best bet is to consult a qualified accountant, lawyer or financial planner.
