Wednesday, September 10, 2008

The New Contrarian Investment Strategy: Chp 11: How You Can Benefit From Innovative Financial Tools

Due to high inflation in the early 80's, there was a tremendous amount of innovation with financial products in order to entice people to continue investing money with financial institutions. Dreman discusses the benefits, drawbacks and things to be cognizant of when using some of these products.

Deep Discount bonds are often discounted 40-55% off of their face values and although the coupon rate is less than many other bonds, it is paid on the full face value. The steep discount to face value offers protection against further interest rate increases. When buying any bond, make sure to shop around and get multiple bids to determine if you are getting a fair price.

Zero-coupon bonds were first introduced by Pepsico and J.C Penney. These bonds don't pay coupons but rather are steeply discounted off face value. The interest paid is implied based on the difference between the purchase price and the face value received at maturity. The advantage of these bonds is the implied coupons are reinvested at the same rate and at redemption the appreciation in the bond is considered capital gains not income.

Dreman identifies that deferred (fixed) annuities were available as early as nineteenth century England! A deferred annuity has the advantage of delaying payments of income and is only taxed upon withdrawal of funds. Dreman warns to only buy annuities that are no-load and avoid ones with heavy annual charges. Also, the problem with fixed annuities is that they are invested in long-term bonds and so the investor's final returns are heavily dependent on interest rate fluctuations. However, investors can avoid fixed-annuities and look to invest in the new variable rate annuities. Dreman advises buying fixed annuities when interest rates are high (Dreman mentions 16-18%) and variable annuities if the rates are low.

At high interest rates, municipal bonds are interesting investment vehicles because of the tax-free yields. For people in higher tax brackets, a tax-free yield at high interest rate can be very attractive. Dreman's warnings include, shopping around for different prices, don't buy lower than a bond rating of AA, don't buy long-term muncipals unless yields are high (Dreman mentions 12%) and be wary of call features that might be embedded in the bonds.

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