InvestY Archives | Page 56 of 97

Sep

2023

What Is a Leverage Ratio?

By Laurel Tincher | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Leverage ratios are a collection of formulas commonly used to compare how much debt, or leverage, a company has relative to its assets and equity. It shows whether a company is using more equity or more debt to finance its operations. Understanding a company’s debt situation is a key part of fundamental analysis during stock research. Calculating its financial leverage ratio helps potential investors understand a company’s ability to pay off its debt.

A high leverage ratio could indicate that a company has taken on more debt than it can pay off with its current cash flows, potentially making the company a riskier investment.

How to Calculate Leverage

A company increases its leverage by taking on more debt, acquiring an asset through a lease, buying back its own stock using borrowed funds, or by acquiring another company using borrowed funds.

There are several types of leverage ratios, which compare a company’s or an individual’s debt levels to other financial indicators. Some commonly used ones are:

Debt-to-Assets Ratio

This ratio compares a company’s debt to its assets. It is calculated by dividing total debt by total assets. A higher ratio could indicate that the company has purchased the majority of its assets with debt. That could be a warning sign that the company doesn’t have enough cash or profits to pay off these debts.

Formula: Total debt / total assets

Debt-to-Equity Ratio (D/E)

The debt-to-equity ratio compares a company’s debt to its equity. It is calculated by dividing total debt by total equity. If this ratio is high, it could indicate that the company has been financing its growth using debt.

The appropriate D/E ratio will vary by company. Some industries require more capital and some companies may need to take on more debt. Comparing ratios of companies in the same industry can give you a sense of what the typical ranges are.

Formula: Total debt / total equity

Asset-to-Equity Ratio

This is similar to the D/E ratio, but uses assets instead of debt. Assets include debt, so debt is still included in the overall ratio. If this ratio is high, it means the company is funding its operations mostly with assets and debt rather than equity.

Formula: Total assets / total equity

Debt-to-Capital Ratio

Another popular ratio, this one looks at a company’s debt liabilities and its total capital. It includes both short- and long-term debt, as well as shareholder equity. If this ratio is high, this may be a sign that the company is a risky investment.

Formula: Debt-to-capital ratio: Total debt / (total debt + total shareholder equity)

Degree of Financial Leverage

This calculation shows how a company’s operating income or earnings before interest (EBIT) and taxes will impact its earnings per share (EPS). If a company takes on more debt, it may have less stable earnings. This can be a good thing if the debt helps the company earn more money, but if the company goes through a less profitable period it could have a harder time paying off the debt.

Formula: % change in earnings per share / % change in earnings before interest and taxes

Consumer Leverage Ratio

This ratio compares the average American consumer’s debt to their disposable income. If consumers go into more debt, their spending can help fuel the economy, but it can also lead to larger economic problems.

Formula: Total household debt / disposable personal income

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Ways to Use Leverage Ratio Calculations

Understanding the definition of leverage ratio and the formulas for various types, is the first step toward using the measurement to make investing decisions. Investors use leverage ratios as a tool to measure the risk of investing in a company.

Simply put, they show how much borrowed money a company is using. Each industry is different, and the amount of debt a company has may differ depending on who its competitors are and other factors, such as its historical profits. In a very competitive industry or one that requires significant capital investment, it may be riskier to invest in or lend to a company with a high leverage ratio.

The interest rates companies are paying matters also, since debt at a lower rate has a smaller impact on the bottom line.

Regardless of industry, If a company can not pay back its debts, it may end up going bankrupt, and the investor could lose their money. On the other hand, if a company is using some leverage to fuel growth, this can be a good sign for investors. This means shareholders can see a greater return on equity when the company profits off of that growth. If a company can’t or chooses not to borrow any money, that could signal that they have tight margins, which may also be a warning sign for investors.

Investors can also use leverage ratios to understand how a potential change in expenses or income might affect the company.

How Lenders Use Leverage Ratios

In addition to investors, potential lenders calculate leverage ratios to figure out how much they are willing to lend to a company. These calculations are completed in addition to other calculations to provide a comprehensive picture of the company’s financial situation.

Overall, leverage ratio is one calculation amongst many that are used to evaluate a company for potential investment or lending.

How Leverage is Created

There are several different ways companies or individuals create leverage These include:

• A company may borrow money to fund the acquisition of another business by issuing bonds

• Large companies can take out “cash flow loans” based on their credit status

• A company may purchase assets such as equipment or property using “asset-backed lending”

• A company or private equity firm may do a leveraged buyout

• Individuals take out a mortgage to purchase a house

• Individual investors who trade options, futures, and margins may use leverage to increase their position

• Investors may borrow money against their investment portfolio

The Takeaway

All leverage ratios are a measure of a company’s risk. Understanding basic formulas for fundamental analysis is an important strategy when starting to invest in stocks. Such formulas can help investors weigh the risks of a particular asset investment and compare assets to one another.

There are numerous ways to use leverage ratios, and lenders can use them as well. In all, knowing the basics about them can help broaden your knowledge and understanding of the financial industry.

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Sep

2023

What Is Quantitative Easing?

By Laurel Tincher | Growing Wealth, Investing, Terminology | No Comments

Quantitative easing (QE) is a monetary policy tool in which a central bank attempts to stimulate growth in the economy by buying bonds or other financial assets in the open market.

When the central bank purchases assets, the money they’ve spent gets released into the market, increasing the money supply in an economy. QE is an unconventional monetary policy tool that’s usually used by a central bank when traditional tools — like lowering interest rates — are no longer effective or an option.

How Does Quantitative Easing Work?

Quantitative easing makes it easier for businesses to borrow money from banks, by essentially lowering the cost of borrowing money.

The Federal Reserve, or Fed, is the central bank of the United States. The Fed notably conducted multiple rounds of QE after the 2008 financial crisis. The U.S. central bank also embarked on a QE program in 2020 when quarantine measures were put in place due to the Covid-19 pandemic.

When the Federal Reserve purchases securities from other banks, it issues a credit to the bank’s reserves, thereby figuratively increasing the money supply. No funds actually change hands in a QE program. The funds used to purchase the securities are essentially created out of thin air as a credit. Hence, QE is often referred to as “printing money” since the central bank is boosting the fiat currency supply.

When the Fed purchases Treasuries from the government, this also keeps Treasury yields low by increasing the demand for them. When Treasury yields stay low, long-term interest rates remain low, which can make it easier for consumers to take out loans for a car, house, or other types of debt.

Banks are required to have a certain amount of money on hand each night when they close their books. This is called the bank reserve requirement. QE gives banks more than they need to hit this reserve requirement. When banks have extra money, they lend it out to other banks to make a profit. This can also help stimulate the economy.

In addition to making it easier for banks to give out loans, QE keeps the value of the U.S. dollar lower, which in turn lowers the cost of exports and makes stocks attractive to foreign investors. All of these factors can help to keep the economy running during challenging times.

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When Low Interest Rates Aren’t Enough

While Congress controls government spending and tax rates — what’s known as fiscal policy — the Federal Reserve controls short-term interest rates, which are the main tool used to prevent or lower the impacts of a recession — a system known as monetary policy.

More specifically, the Fed adjusts the rate that banks have to pay to one another to loan money that is held in Fed accounts. If banks can borrow money at a lower rate, they in turn can lend money to their customers at a lower rate.

Central banks have long preferred to lower short-term interest rates to expand the economy and encourage more spending. Similarly, the Federal Reserve raises interest rates to slow inflation. But when interest rate cuts aren’t enough to stimulate the economy, as is now the case, quantitative easing is sometimes used as a last resort.

One limitation on interest rates is that they can’t practically be lowered to less than zero. Technically, negative interest rates are possible, but this would mean that banks would actually be paying people to borrow money, rather than the other way around.

When interest rates fall to near zero, and banks, corporations, and individuals hoard money, this results in a lack of liquidity in the market. Quantitative easing can help release money back into the market. The asset purchases will take place over the course of several months. The goal is to make sure that businesses have sufficient funds to lend to other businesses throughout the economic downturn.

Does Quantitative Easing Cause Inflation?

One of the biggest fears about quantitative easing is that it will cause too much inflation, or price increases. In such a scenario, inflation would occur because there’s a lot of money in the system.

Some economists argue that if the money supply increases quickly, it increases demand as more people have ample money to spend. That, in turn, can raise prices rapidly or encourage reckless financial decisions.

Some degree of inflation is healthy and normal. For instance, in the U.S., the Federal Reserve targets an inflation rate of 2%. But inflation rates that are too high can be painful for consumers. For instance, during the 1970s, the inflation rate averaged 7% and hit double-digit levels in 1974 and 1979, causing the prices of some goods — most notably oil — to skyrocket.

Past Examples of Quantitative Easing

A relatively new strategy, quantitative easing has been used a number of times over the past 20 years, with varying degrees of success.

Quantitative Easing in Japan

The first example of an advanced first-world country implementing a quantitative easing program was Japan in 2000-2006. Japan entered into a recession following the Asian Financial Crisis of 1997.

The Bank of Japan bought private debt and stocks through the QE program, but the program didn’t result in the stimulus they had hoped for. Japan’s GDP fell from $5.45 trillion to $4.52 trillion between 1995 and 2007. Japan also used QE in 2012 when Prime Minister Shinzo Abe was elected and sought to stimulate the economy.

Quantitative Easing in the US

A few rounds of quantitative easing took place throughout the financial crisis from 2008 to 2011.

The most successful example of QE was the $2 trillion stimulus enacted by the U.S. in 2008, despite the fact that it doubled the national debt from $2.1 trillion to $4.4 trillion in just a few years. Although many feel that the QE program helped get the U.S. and global economy through the recession following the financial crisis, this topic has been debated and is hard to quantify.

Some critics argue that banks actually held on to much of the excess money they received through the QE program rather than lending it out, so the program didn’t exactly have the desired effect. However, QE helped to remove subprime mortgages from bank balance sheets and bring the housing market back.

Quantitative Easing in Switzerland

During the 2008 financial crisis, the Swiss National Bank also implemented a QE program. In terms of its ratio to GDP, the Swiss program was the largest ever enacted in the world.

Despite this overwhelming effort that resulted in some economic growth, Switzerland didn’t reach its inflation targets after the use of QE.

Quantitative Easing in the UK

In 2016, the Bank of England launched a QE program worth £70 billion to help alleviate economic concerns about Brexit.

Between 2016 and 2018, business investment grew in the U.K., but it was still growing at a slower rate than it had been in previous years. Economists have not been able to confirm whether growth would have been even slower without the QE program.

Pros and Cons of Quantitative Easing

While QE programs can help stimulate a struggling economy, they have some downsides, and there are reasons they are used as a last resort.

Pros of Quantitative Easing

• QE programs make it easier for businesses to take out loans.

• The influx of money into the market can help keep the economy flowing and release liquidity traps.

• Low interest rates make it easier for consumers to take out loans for cars, homes, and other borrowing needs.

• QE can be an important tool during a financial crisis in order to avert recession, or even severe economic depression.

Cons of Quantitative Easing

• Increasing the supply of money can lead to inflation.

• Stagflation can occur if the QE money leads to inflation but doesn’t help with economic growth. The Fed can’t force banks to lend money out and it can’t force businesses and consumers to take out loans.

• QE can devalue the domestic currency, which makes production and consumer costs higher.

• As a relatively new economic concept, there isn’t data and consensus about whether QE is effective.

What If QE Doesn’t Work?

Previous QE programs implemented by Japan, Switzerland, and the U.K. have not managed to reach the stimulus goals they set out to achieve. However, the QE program enacted in the U.S. during the 2009 recession helped to revive the housing market, stimulate the economy, and restore trust in banks. It didn’t cause rampant inflation as many feared it would.

It’s unclear how effective it was following stimulus measures implemented during the COVID-19 pandemic, too. As a relatively new strategy, there isn’t enough data to confirm whether QE is effective. In fact, there isn’t even agreement about how exactly it’s supposed to work.

Flattening the Yield Curve

Economists have a theory that quantitative easing will work by flattening the yield curve, which is a graph curve that displays the variation of interest rates according to their term of maturity. When the Fed purchases long-term Treasuries, their yield goes down and their prices go up.

This results in the yields of corporate bonds and long-term mortgages going down as well. Lower rates encourage home construction, corporate investment, and other activities that stimulate the economy. Although this sounds good in theory, the issue in the current economy is that the yield curve is already pretty flat.

Losing Effectiveness

A QE program might stimulate the economy for a short amount of time, but it could also lose its effectiveness. If this happens, the government can also turn to fiscal policy, or government spending, to further put money into the economy.

Sometimes QE and government spending can blur together, if the Fed purchases government bonds that are issued to fund government spending.

Some economists also believe that by signaling to the world that the Fed is serious about stimulating the economy, this will help create economic growth and spending and make consumers confident about making purchases. Whether this is true is yet to be seen in the current global situation.

The Takeaway

Quantitative easing is an unconventional monetary policy tool that central banks can use when faced with weak or nonexistent growth. Central banks typically resort to measures like QE when more conventional monetary policy tools, such as lowering interest rates, are no longer effective or not enough to stimulate an economy.

QE is a relatively new phenomenon, but it became more common after the 2008 financial crisis, when multiple central banks around the world resorted to asset purchases to boost economic growth.

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Sep

2023

7 Factors That Cause Inflation

By Colin Dodds | invest, Investing, Preparing for Retirement | Comments Off

There are a number of factors that can cause inflation, including an increase in the cost of raw materials, an increase in the currency supply, and more. When the cost of goods and services rise over time, and consumers have to spend more to buy basic items, that’s considered inflation.

Inflation is an economic reality, but the government tries to regulate inflation so that it remains at a low but steady pace. The target is 2.0%, but historically it’s closer to 3.3%. A period of higher inflation began in early 2021, thanks in part to supply chain bottlenecks resulting from the pandemic.

Inflation isn’t necessarily a bad thing — it can also result from an economic upturn. But when the prices of goods and services rise in relation to the dollar, or the currency in use, the result is that each unit of currency will buy less of just about everything than it previously did.

Here’s a closer look at how to track inflation, and seven factors that cause prices to increase.

How to Track Inflation

The most commonly used measure to track inflation is the Consumer Price Index (CPI), which is produced by the U.S. Bureau of Labor Statistics (BLS) each month. The CPI tracks the average of prices of a set of goods and services. While the CPI leaves out important aspects of consumer spending, such as real estate and education, it is considered a valuable gauge of the ever-changing cost of living.

What Is Core Inflation?

Core inflation also measures the rising cost of goods and services, but it excludes food and energy costs. The reason being that both food and energy prices are partly driven by the price of commodities — which tend to be volatile, owing to speculation in the commodities markets. So the short-term price changes in food and energy make it difficult to include them in a long-term reading of inflationary trends: hence the core inflation metric.

The Consumer Price Index and the core personal consumption expenditures index (PCE) are the two main ways to measure underlying inflation that’s long term.

Inflation also shows up in the wholesale price index (WPI), which measures and tracks the changes in the price of commodities and other goods that are traded between businesses.

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Types of Economic Inflation

There are a range of different types of inflation, although they are fundamentally interrelated.

Cost-Push Inflation

Cost-push inflation occurs when the price of commodities rises, pushing up the price of goods or services that rely on those commodities. For example, owing to high demand for certain types of minerals used in technology equipment, the prices for those goods are likely to rise.

Demand-Pull Inflation

Rising demand for goods and services can trigger inflation when there’s an imbalance in supply vs. demand. This is known as demand-pull inflation. For example, if there’s a high demand for pork (or if there’s a slump on the supply side owing to pork shortages), that could drive up the price of bacon, ham, and other pork products.

Built-In Inflation

Built-in inflation is the result of an upward spiral in wages, as workers seek raises to keep up with the cost of living. This in turn can lead businesses to raise their prices, adding to the higher prices.

As you can see, these three types of inflation are connected through the loop of supply and demand.

Recommended: 5 Tips to Hedge Against Inflation

What Causes Inflation?

While inflation has become a persistent factor in most of the world’s economies, it can result from a range of different causes. Understanding the different causes can help investors manage inflation risk — i.e. the possibility that the money you invest won’t earn enough to keep up with inflation.

1. The Economy Is Going Strong

When the economy is growing, more people have jobs, wages increase in order to hire and keep those workers, and more people have money to spend. As a result, they buy more necessities and some even splurge on luxury items.

In this environment, businesses can increase their prices, and consequently, wholesalers can increase prices. The net result of this cycle of expansion is higher prices across the board: aka inflation.

This scenario is why inflation isn’t always bad news. In fact, the Federal Reserve aims for a target annual inflation rate of around 2%, because it indicates a growing economy. As noted above, this kind of inflation is a type of “demand-pull inflation,” because it is driven by consumer demand.

In fact, deflation — when the prices of goods fall for a period of time — can also be considered unhealthy because it can mean demand among consumers is weak.

2. There Is More Currency Available

Inflation can also occur when the Fed, or another central bank, adds fiat currency into circulation at a rate that exceeds that of the economy’s growth rate. That creates a situation in which there are more dollars bidding on fewer goods and services. The result is that goods and services cost more.

One reason that inflation has been a constant in the U.S. since 1933 is that the Fed has continually increased the money supply. In response to the 2008 financial crisis, the Fed dropped its lending rate close to zero as a way to inject more liquidity into the economy, which led to increased inflation but not hyperinflation. While those increases have usually moved in step with growth, that hasn’t always been the case.

In response to the Covid-19 pandemic and subsequent lockdowns, the Fed released the equivalent of $3.8 trillion in new liquidity in 2020. That amount was equal to roughly 20% of the dollars previously in circulation. And it is one reason why many investors were watching the CPI closely in 2021 — and were not surprised when inflation began to climb through 2022.

3. Basic Materials Increase in Price

In the 1970s in the U.S., inflation was rampant. There were many reasons for this, but one major one was the OPEC oil embargoes. The embargoes led to a gas shortage, higher prices for home-heating oil, higher prices at the pump, and increases in the prices of manufacturing and shipping for nearly every single consumer good.

Between 1973 and 1974, inflation-adjusted oil prices jumped from $25.97 per barrel to $46.35. And as a result, inflation topped 11% that year.

Another one of the most dramatic periods of inflation was the period of 1979-1981, when inflation topped 10% for three straight years. Again, oil was a major contributing factor, as the Iranian Revolution set off further increases in the price of oil.

Recommended: Guide to Investing in Oil

4. The Housing Market Takes Off

The housing market is a major part of the U.S. economy, and it has an outsized impact on the broader economy. When the housing market is strong and home prices are rising, then homeowners have more equity to call upon to make major purchases, which can goose inflation.

At the same time, a strong housing market means that homeowners, contractors, and builders are spending more on home improvements and buying the raw materials that make those new and improved homes possible. That, in turn, drives up the prices of those raw materials, such as steel, lumber, and oil, which can lead to more inflation.

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5. The Government Implements Expansionary Fiscal Policies

The federal government will occasionally try to jumpstart economic growth with new policies. These expansionary fiscal policies often seek to increase the amount of discretionary income that businesses and consumers have to spend.

Often, these policies take the form of reduced taxes with the belief that businesses will spend it on employee compensation and new hiring. That will allow more consumers to spend on goods and services.

Other times, those policies consist of massive infrastructure projects, which can increase the demand for goods and services. The increasing of overall liquidity due to central bank monetary policy is also considered an expansionary policy.

6. New Regulations Increase Costs

While a shortage of an essential commodity, like oil, can cause inflation, so can an increase in costs related to a commodity suddenly becoming more expensive because of government regulations.

Sometimes new tariffs can increase the costs of imported goods, which can lead to inflation. At the same time, new regulations that make a particular commodity or service more expensive or time-consuming to obtain can also increase the costs to consumers, leading to inflation.

7. The Exchange Rate Changes

The value of the U.S. dollar in relation to all other foreign currencies is constantly in flux. If the dollar goes down, then imported commodities and consumer goods get more expensive. But it also makes goods exported from the U.S. cheaper abroad, which can actually be a boost for the economy.

The Takeaway

Inflation in the U.S. has been a constant since 1933. Most years inflation is a slow drip of almost imperceptible price increases, but there have been times when it has risen sharply, as it did during the late 70s and early 80s. This was a painful period for many consumers and inflation became a major political issue.

Inflation was fairly gradual in the decades since then, but after stimulus packages during the Covid-19 pandemic and a reopening of the economy boosted prices and growth, inflation took off. It reached a peak of about 9.02% in June of 2022, and has eased down closer to the historical average of about 3.28% throughout 2023.

The forces that can stir or mitigate inflation are important for investors to understand. Managing your investment strategy in light of the inevitable impact of inflation can help offset inflation risk — the risk that your money won’t retain its purchasing power in the future.

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FAQ

How does raising interest rates help inflation?

Higher interest rates may help slow spending, because the cost of borrowing increases as rates rise. People may also be inclined to take advantage of higher rates by saving more, which can also slow demand and cool the economy.

How quickly does inflation decrease to normal levels?

Cycles of inflation historically have lasted many years, or a couple of months. How quickly inflation subsides depends on economic conditions overall, as well as the origins of a particular bout of inflation. If employment numbers change, if interest rates rise or fall, if demand overshoots supply — these are among the factors that can influence inflation.

Who benefits from inflation?

There are a couple of scenarios where inflation can be beneficial. For example, those with bigger debts can benefit from inflation because the money they’re using to pay off their car or home loan, say, is now less valuable than the money they borrowed. Those working in jobs made more secure by rising demand can also benefit. In some cases, holding foreign currency may be more beneficial in relation to the inflationary currency. Inflation is fluid, and it’s important to gauge which factors are at play before deciding what is beneficial or not.

Who is hurt most by inflation?

Lower-income households are disproportionately affected by inflation, because the cost of goods and services is rising faster than wages. Another group hit hard by inflation is retirees and those living on fixed incomes, because their money is buying less over time.

Photo credit: iStock/Delmaine Donson

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Sep

2023

What Is Tax Lien Investing?

By Colin Dodds | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Tax lien investing involves an investor buys the claim that a local government makes on a property when an owner fails to pay their property taxes. Each year, states and municipalities sell billions of dollars in tax liens to the public.

The lien itself is a legal claim of ownership that a city or county makes against any property whose owner hasn’t paid taxes. The government then sells those claims, usually at auction, to investors. It is considered an alternative investment and a way to get real estate exposure in a portfolio.

How Tax Lien Investing Works

Tax lien investing involves an investor purchasing a property at auction that currently has a tax lien against it. They pay off the lien, and then the property is theirs, typically purchased as an investment.

If an investor wins a tax lien certificate at auction, they must immediately pay the state or local government the full amount of the lien. Then entitled to collect the property’s tax debt, plus interest and penalty fees. The interest that the property owner must repay the investor varies from state to state, but is usually in the 10%-12% range, using a simple interest formula. Some states charge as much as 2% per month on tax liens.

Property Tax Liens Explained

Between 2009 and 2022, historically low interest rates led many income-oriented investors have started to look more closely into buying tax lien certificates as a way to generate more returns from their portfolios. With relatively high interest rates, tax liens offer one way to generate investment income. Unlike many other interest rates, the rates on property taxes aren’t affected by market fluctuations, or decisions by the Federal Reserve. Instead, state statutes set the interest rates on overdue taxes.

That makes tax liens a potentially attractive alternative investment in a period of rock-bottom interest rates. But they come with their own unique risks. For starters, the investor only realizes the high interest rates if the property owner agrees to pay them.

The fact that the property owner is delinquent on their taxes may indicate, however, that they’re in a bad state financially, and unable to pay back the new owner of the lien. In that case, the only way for an investor to recoup the initial cost of buying the lien, plus interest and penalty fees, is to foreclose on the property and sell it. In that situation, the investor gets the money from the proceeds from the sale.

The good news for tax lien investors is that the lien certificate they receive from the local government usually supersedes other liens on the property, including any mortgages on it. That entitles the tax-lien investors to full proceeds from a foreclosure sale in most cases. The only creditor on a property who may have priority over tax-lien investors is the federal government for liens imposed by the Internal Revenue Service.

The bad news is that the lien certificates don’t, in any circumstances, give the investor ownership of the property. In cases where the property owner doesn’t pay the investor the money owed, a tax-deed foreclosure is the only way an investor can get paid.Those proceedings, along with eviction, repairs and other costs, can cut into returns made by the investor.

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How to Buy Tax Liens

Not every state allows the public auction of overdue property taxes, but thousands of municipalities and counties across the country currently sell tax debt to the public.

For a new investor, one place to start looking into buying tax liens is by getting in touch with your local tax revenue official. They can point you to the publication of overdue taxes. Most states advertise property tax lien sales for before the actual sale. Most of the time, these advertisements let you know the property owner, the legal description of the property, and the amount of delinquent taxes.

How Do Tax Lien Sales Work?

Tax lien sales often, or mostly, happen at auction. The auctions themselves vary by municipality and state. Some are online, and others are in person. Some operate by having the investors bid on the interest rate. In this auction format, the municipality sets a maximum interest rate, and the investors then offer lower interest rates, with the lowest bidder winning the auction.

In another popular auction format, investors bid up a premium they’re willing to pay on the lien. In this format, the bidder who’s willing to pay the most — above and beyond the value of the lien — wins. But the investor can also collect interest on that premium in many cases.

If that sounds like too much work and research, investors can access this unique asset class by purchasing shares in a tax lien fund run by an institutional investor. Institutional investors may have the research, focus, and experience new investors may not have, or want to develop. Professional investors also have experience with some of the litigation and other expensive pitfalls that can come with a property foreclosure.

Tax Lien Investing Risks

As a financial asset, tax liens offer a unique opportunity for income, but they also have their own set of risks. The first is the property itself. The neighborhood and condition of the property make a difference in the value of the property and the ease with which an investor can sell it.

Another investment risk to keep in mind is that some owners may never pay back the property taxes they owe, and if the value of the property, after foreclosure, may not pay back the money invested in the lien. Investors also may have to deal with a property embroiled in litigation, or on which other creditors have a claim. This is one area where research can make a big difference.

Also, liens don’t last forever. They come with expiration dates, after which the owner can no longer foreclose on the property or collect overdue taxes and interest from the property owner. In some cases, investors will pay taxes on the property to which they own the lien for years, just to keep a claim on the underlying property. This can be a smart strategy if it gets the investor the property at a lower price, but it can also create opportunity costs.

Finally, the overall returns on tax liens are going down in many cases, as more large institutional investors start bidding on tax lien auctions. More bidders drive down the interest rates or drive up the premiums, depending on the auction format.

Benefits to Investing in Tax Liens

Investing in tax liens also has its potential benefits, including the chance of generating outsized returns (but keep the risks in mind, too). Sometimes, properties can be purchased for a relative bargain — such as a few hundred or a few thousand dollars, which can obviously be attractive to investors, though it may not be typical. Tax lien investing is another way to diversify a portfolio as well.

The Takeaway

Tax lien investing involves buying the claim that a local government makes on a property when an owner fails to pay their property taxes. Once an investor buys that claim, they then pay off the back taxes, and take ownership of the property. Each year, states and municipalities sell billions of dollars in tax liens to the public, making for ample opportunity.

Tax lien investment can offer an alternative investment that balances out a diversified portfolio, but it has many risks that individual investors should understand. Of course, there are plenty of other ways that investors can put their money to work for them.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

How can you get started in tax lien investing?

Prospective tax lien investors can get in touch with local tax officials to learn more about tax liens in their area, or do some internet searches to find when and where auctions are taking place. They can then bid and potentially win a claim on a property.

What’s the difference between tax liens and mortgage liens?

Tax liens are placed on a property by the government for unpaid property taxes, whereas a mortgage lien is placed on a property by a lender in order to secure it for a borrower failing to pay their home loan.

Are IRS tax liens public record?

IRS tax liens are federal tax liens, and are public record. The IRS will file a public document to alert others in the even that a federal lien is being placed on your property.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Sep

2023

Exchange-Traded Notes: What Are ETNs? ETN Risks, Explained

What Is an Exchange-Traded Note (ETN)?

By Ashley Kilroy | Growing Wealth, invest, Investing | Comments Off

Exchange-traded notes, or ETNs, are debt securities that offer built-in diversity, and offer alternatives to other investment vehicles that may have certain problems for investors, like tracking errors and short-term capital gains taxes.

ETNs are similar to ETFs (exchange-traded funds), in that they may be a popular pathway to diversification because they expose investors to a wide range of financial assets, and come with lower expense ratios compared to mutual funds. As such, it can be beneficial for investors to understand ETNs and how they work.

What Is an Exchange-Traded Note (ETN)?

An ETN, or an exchange-traded note, is a debt security that acts much like a loan or a bond. Issuers like banks or other financial institutions sell the “note,” which tracks the performance of an underlying commodity or stock market index benchmark.

ETNs do not yield dividends or interest in the way that ETFs do. Before investors can earn a profit from an ETN, they must hold the security long enough for it to mature — typically ten to thirty years. Upon maturity, the ETN pays out one lump sum according to their underlying commodity’s return.

Exchange-Traded Notes Meaning

The term “exchange-traded note” may sound a bit off to some investors, but its meaning is fairly straightforward. For one, ETNs are “exchange-traded” because they’re literally traded on exchanges, like many other securities. And they’re called “notes” because they are debt securities, not pools of investments like a fund (as in ETF).

Examples of ETNs

To further illustrate how an ETN works and is constructed, suppose you purchase an ETN that tracks the price of gold. As an investor, you don’t own physical gold, but the note’s value tracks gold’s performance. When you sell the ETN, during or at the end of the holding period, your return will be the difference between gold’s sale price at that time and its original purchase price, deducting any associated fees.

Similarly, you could, hypothetically, create an ETN that tracks the price of a commodity like oil. Again, investors don’t actually own barrels of crude, but the ETN would track oil prices until it matures, and then pay out applicable returns.

💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Pros of ETNs

ETNs are a relatively newer type of financial security compared to some others available on the market. Their design comes with perks that some investors may find appealing.

Access to New Markets

Some individual investors may struggle to access niche markets like currencies, international markets, and commodity futures, since they require high minimum investments and significant commission prices. ETNs don’t have these limitations, making them more available to a larger pool of investors.

Accurate Performance Tracking

Unlike ETFs, ETNs don’t require rebalancing. That’s because ETNs do not own an underlying asset, rather they duplicate the index or asset class value it tracks. This means investors won’t miss any profits due to tracking errors, which means a difference between the market’s return and the ETF’s actual return.

Tax Treatment Advantages

Investors of ETNs don’t receive interest, monthly dividends, or annual capital gains distributions — which in turn means they don’t pay taxes on them. In fact, they only face long-term capital gains taxes when they sell or wait for an ETN to mature.

Liqudity

Investors have two options when selling ETNs: They can buy or sell them during regular day trading hours or redeem them from the issuing bank once a week.

Cons of ETN

Every investor must be wary of their investments’ drawbacks. Here are some potential cons of trading ETNs.

Limited Investment Options

Currently, there are fewer ETN options available to investors than other investment products. Additionally, though issuers try to keep valuations at a constant rate, pricing can vary widely depending on when you buy.

Liquidity Shortage

ETFs and stocks can be exchanged throughout the trading day according to price fluctuations. With ETNs, however, investors can only redeem large blocks of the security for their current underlying value once a week. This has the potential to leave them vulnerable to holding-period risks while waiting.

Credit, Default, and Redemption Risk

There are a range of risks associated with ETNs.

1. Risk of default. An ETN is tied to a financial institution such as a bank. It’s possible for that bank to issue an ETN but fail to pay back the principal after the holding period. If so, they’ll go into default, leaving you with a loss. There’s no absolute protection for owners in this case since ETNs are unsecured. External and social factors can lead to a default, too, not just economic influences.

2. Redemption risk. Investors can also take a loss if the institution calls its issued ETNs before maturity. This is called call or redemption risk. In this case, the early redemption may result in a lower sale price than the purchase price, leading to a loss.

3. Credit risk. The institution that issues the ETN impacts the credit rating of the security, which has to do with credit risk. If a bank experiences a drop in its credit rating, so will the ETN. That leads to a loss of value, regardless of the market index it tracks.

ETN vs. ETF: What’s the Difference?

Comparing ETNs and ETFs may help investors to see the pros and cons of either asset more clearly. Both ETNs and ETFs are exchange-traded products (ETPs) that track the metrics of an underlying commodity they represent. Other than that, though, they operate differently from each other.

Asset Ownership

ETFs are similar to a mutual fund, in that investors have some ownership over multiple assets that the ETF bundles together. You invest in a fund that holds assets. They issue periodic dividends in returns as well.

In comparison, ETNs are debt instruments and represent one index or commodity. They are an unsecured debt note that tracks the performance of an asset but doesn’t actually hold the asset itself. As a result, they only issue one payout when you sell or redeem them.

Taxation

These differences impact taxation. An ETF’s distributions are taxable on a yearly basis. Every time a long-term holder of a conventional ETF receives a dividend, they face a short-term capital gains tax.

Comparatively, ETN’s one lump-sum incurs a single tax, making it beneficial for investors who want to minimize their annual taxes.

Recommended: ETF Trading & Investing Guide

The Takeaway

ETNs are unsecured debt notes that track an index or commodity, and are sold by banks and other financial institutions. Like any investment, ETNs have both benefits and drawbacks — and while they may sound like ETFs, there are differences between these two products, notably that with ETNs you do not own any underlying assets.

ETNs may have a place in an investment portfolio, but it’s important that investors fully understand what they are, how they work, and how they can be incorporated into an investment strategy. It may be helpful to speak with a financial professional for guidance.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

Who developed ETNs?

Barclays, a large international bank, first developed exchange-traded notes (ETNs) in 2006 as a way to give retail investors an easier path to investing in asset classes like commodities and currencies.

How is an ETN related to ETPs?

ETPs, or exchange-traded products, is a term that refers to a range of financial securities that trade on exchanges. ETNs, or exchange-traded notes, fall under the ETP umbrella, since they are investments that trade on exchanges.

Where are ETNs listed?

ETNs are listed on different exchanges, and can often be found by searching for their respective ticker or symbol.

Photo credit: iStock/Drazen_

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

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