Thursday, January 26, 2012

Education Expensive? Try Taxes!

Education is expensive.  Those of you paying, or planning to pay, tuition know that is a truism.  It costs a lot to prepare for occupations that require higher levels of education, yet a quality education typically pays for itself with a lifetime of earnings that greatly exceed the costs.

 

To help with these costs the United States Government has extended several tax breaks to help qualifying individuals and families reduce the cost of education, by providing a subsidy through the tax system.  For 2012, the American Opportunity Tax Credit and the Lifetime Learning Credit continue to exist, following being extended in 2010 for continuance through 2012.  What are they?

 

The Lifetime Learning Credit provides a $2,000 tax credit per return, if one or more students are enrolled in one or more courses at a qualified educational institution.  The tax credit is designed for those with incomes below statutory limits.  Single filers begin to lose this tax credit when their Adjusted Gross Income (AGI) reaches $50,000 and it disappears completely at an AGI of $60,000.  Married tax payers begin to have their Lifetime Learning Credit phased out at an AGI of $100,000, becoming completely exhausted at an AGI of $120,000.

 

The American Opportunity Tax Credit provides a maximum tax credit of $2,500 per student per tax year for the first four years of higher education expenses.   It is fully available to single taxpayers with an AGI of under $80,000 and is phased out to zero when their AGI reaches $90,000.  For married taxpayers, the credit begins to disappear at an AGI of $160,000, becoming zero at an AGI of $180,000.  A nice characteristic of the American Opportunity Tax Credit is that tax filers that do not owe federal income taxes are still eligible to receive up to 40% of the credit, or $1,000, as a refundable tax credit.

 

If you claim either tax credit, you are unable to take an “above-the-line” tax deduction, also known as an adjustment to income used to calculate Adjusted Gross Income.  The education deduction allows one to claim up to a $4,000 deduction, if the taxpayer’s Adjusted Gross Income is not greater than $65,000 for a single filer or $130,000 for joint filers.  This allowable deduction reduces to $2,000 for single-filers with Adjusted Gross Income of $80,000, or $160,000 for joint filers.

 

Let’s assume you are single with an Adjusted Gross Income of $30,000 and, thus, in the 15% marginal tax bracket, implying you would pay $0.15 in taxes on the next dollar you earn.  While a $4,000 deduction sounds larger than a $2,500 tax credit, it would only reduce your taxes by $600 (=$4,000 * .15).  On the other hand, a tax credit reduces your taxes dollar for dollar.  If you are single and claim the American Opportunity Tax Credit, the $4,000 in educational expenses would allow you to take a $2,500 tax credit.  Thus you have reduced your taxes by $2,500, which is 4.17 times greater than if you had taken the “above-the-line”, $4,000 tax deduction.   To repeat:  A tax credit reduces your taxes dollar for dollar, while a tax deduction reduces your taxes by the amount of the deduction times your marginal tax rate.

 

Additional tax breaks for students do exist.  Student loan interest up to $2,500 is tax deductible.  Teacher classroom expenses are deductible up to $250 for teachers.  Moreover, if your employer provides educational benefits, up to $5,250 in employer provided education assistance is not included in calculating your income.

 

If you have young children and you believe that education is correlated with financial success, Coverdell Educational Savings accounts and state 529 plans allow for tax-free contributions to college savings plans, assuming that the money is eventually used for higher education expenses.  These can be a very efficient way to reduce taxes, while saving money for college and a great way to commit to your human capital or that of your descendants.  

 

For more information on the Missouri 529 plan, see https://missourimost.s.upromise.com/ .

More information on taxes may be found at http://www.cch.com/wbot2012/017Education.asp .

If you live in central Missouri and qualify for free Volunteer Income Tax Assistance, consider having our trained preparers help you.  Click for locations and hours.

 

 

Thursday, January 19, 2012

Living on Less: 114 Ideas

by Brenda Procter, M.S.

 

Learning how to spend less but still live well takes skill, determination and know-how - but it can be done! Before you buy, ask yourself, “Is there another way to get what we need or want? Can we recycle? Share someone else’s? Make rather than buy? Rent? Trade? Or use public services?” These are all ways to stretch resources when you have to.
 

This article includes more than 100 ideas to help you live on less. These ideas are designed to help you meet your needs after income has been reduced. Most of the ideas are practical, everyday things you can do to cut expenses.

 

You may already be using some of these ideas and not every idea will work for you. Choose the ones that will be the most helpful. As you hear of new ideas that you might consider trying, add them to the list. This is a handy reference when you plan your family budget.
 

Remember to keep your family’s needs in mind. Then use these ideas to help you think of ways to increase or extend your resources.

 

Food

·         Plan your meals one week at a time. Take advantage of specials and seasonal foods. Plan meals around featured sale items to cut food costs.

·         Make a shopping list. When you get to the store, stick to your list to cut down on impulse buying.

·         Buy generic or store brands. The quality is usually acceptable, the nutritive value can be the same as brand-name products and the price difference can be considerable.

·         Shop for food once each week to save gas, time and money.

·         Shop at discount grocery stores - convenience store prices are higher.

·         Avoid shopping when you’re hungry so you can resist impulses.

·         Check out day-old bread stores. They offer significant savings on bread and some other items that are still of acceptable quality.

·         Make a pound of hamburger go further by adding bread crumbs, oatmeal or tomato sauce. You are stretching a high-cost food item with low-cost products.

·         Shop alone. Other family members may want items not on the list.

·         Look for coupons before you go, but only for what you would buy anyway. Some stores double coupon amounts for additional savings.

·         Check out when supermarkets discount meat, produce and bakery goods as day-old goods. The quality may still be acceptable.

·         Use economy cuts of meat like chicken thighs and chuck roast. They provide good-quality protein at a lower cost.

·         Use your oven efficiently and bake more than one dish at a time. The energy savings can be used to supplement other parts of your budget.

·         Plan a meatless day each week. Meat is one of the more expensive foods in our diet. Check your library for cookbooks that have Mexican, oriental or pasta recipes that may feature beans, cheese or vegetables instead of meat.

·         Mix one part of reconstituted instant milk with one part of 1 percent or 2 percent milk. Again, you are stretching a high-cost product with a low-cost one in a way that will not likely be noticed by your family.

·         Buy skim milk. The lower the fat, usually the less expensive the milk.

·         Compare prices per unit: pound, ounce, dozen or package. Take your calculator with you. Comparing cost per unit allows you to accurately compare products of differing sizes.

·         Plan how to use leftovers. Millions of dollars worth of food go to waste each year.

·         Wrap and store foods carefully to prevent waste and health hazards.

·         Make your own convenience foods. The more convenience built into a food product, the higher its price. Check with your library for cookbooks that specialize in homemade mixes.

·         Entertain with potlucks, or simple, inexpensive foods like casseroles and salads. Rethinking what we serve and how we entertain can save on company meals.

·         Take nutritious snacks like fruit or oatmeal cookies with you to work for break time. Vending machines can be expensive.

·         Growing your own fruits and vegetables can sometimes save money.

·         Preserve fresh fruits and vegetables by canning (if you already own or can borrow the canning equipment), freezing or drying.

·         Form or join a food co-op. Check with your Community Action Agency to see if there is one in your area. Food co-ops buy in bulk so you don’t pay for expensive product packaging.

·         Prepare brown-bag lunches when possible. Take leftovers for lunch - eating out is expensive.

·         Cut down on meals away from home. Eating at home usually saves money.

·         Take advantage of the school lunch program. This program can provide well-balanced lunches to children at a reasonable cost. Check about qualifying for reduced-price or free lunches.

·         Ask the local Family Services Division Office if you qualify for food stamps.

·         Use the WIC (Women, Infants and Children) nutrition program if you qualify. This program provides vouchers for many nutritious foods. Check with your local health department.

·         If your family stays healthy, you will save on medical bills. Make sure everyone eats nutritious meals. Use the USDA’s MyPyramid as your food guide. Go online to mypyramid.gov and make your own food pyramid based on your size, age, gender and activity level. This is a free service.

 

Clothing

·         Buy any needed clothing on sale. End-of-season sales often offer some of the best savings.

·         Swap clothes with friends or neighbors. Many children’s garments are still in good shape when a child grows out of them. You can exchange items you have for items you need.

·         If you cannot start a swap program, take clothing to a consignment shop where they will give you money or trade yours for others in stock.

·         Shop for clothing at yard sales to save considerably on slightly used items. This is especially true of children’s clothing or maternity wear.

·         Before buying any garment, check the fabric labels and care instructions. Avoid clothing that requires expensive care like dry cleaning.

·         Read and follow care instructions to make clothes last longer.

·         Encourage family members to hang up clothes after wearing to eliminate unnecessary laundry. The cost of doing a load of laundry is no longer a minor expense.

·         To get more life from each pair of shoes, do not wear the same pair all the time. Resting shoes between wearings extends their overall life.

·         If they’re not dirty, wear clothes more than once before washing.

·         Use a coin-operated dry cleaner for savings on items that must be dry cleaned.

·         Keep clothes in good repair, so a minor problem does not get worse.

·         If you buy a factory second, check the item for flaws. Some flaws you can live with, but some you cannot.

·         Investigate whether using cloth diapers and laundering them yourself is a reasonable option.

·         Hang laundry out to dry. The average cost of a load dried in an electric dryer is higher than using a gas dryer.

·         Clean and polish dress shoes often to keep them in good condition. They will look good longer and will need replacing less often.

·         Store clothes properly to prevent damage from sun, moths, mildew or stretching.

·         Spot clean clothes promptly and save on cleaning by careful wear.

·         Wear old clothes for messy jobs. Try to anticipate tasks that would cause damage to better clothing and take the time to change.

 

Transportation

·         Use self-service gas pumps. Remember to check oil and water levels to keep from having unnecessary repair bills in the future.

·         Keep your car in good condition. It is safer and less expensive to operate a well-maintained automobile.

·         Protect against salt damage and rust by keeping your car clean. This will extend the life of your car.

·         Read and follow the instructions in the owner’s manual. The recommendations can keep your car operating more efficiently for more miles.

·         Learn how to maintain your car. Change oil, air filters and oil filters when recommended. Doing it yourself can cut costs considerably.

·         Take advantage of auto repair classes held in your community. A major portion of auto maintenance or repair costs is the labor. Using your own skills can trim these costs.

·         Get to know which gas stations in your community sell good-quality gas at the lowest rates. Gas up when you are in the area rather than making a special trip to save a few cents per gallon.

·         Walk more, drive less to save money and improve your health.

·         Form car pools for going to work, meetings, children’s activities and shopping trips. The average family spends 18 percent of their income on transportation.

·         Save on fuel with good driving habits (like slowing down gradually rather than braking at the last minute).

·         Save money by washing and waxing your own car.

·         Organize your errands to eliminate unnecessary trips.

·         Try to get along with fewer cars. Automobiles are expensive to own when you include the cost of insurance, taxes and maintenance.

·         Use school and public transportation whenever possible.

·         Consider carrying just liability coverage on any automobile that no longer has much dollar value. The ongoing cost of collision and comprehensive coverage may not make sense given what you would be paid if you had a claim.

 

Personal Habits

·         Barter talents and resources. Trade skills like typing, wallpapering, painting, sewing or hair trimming with a friend or neighbor. You can obtain things you need without spending money.

·         Give a gift of your own personal services. Window washing, baby-sitting, lawn mowing and garden weeding are all examples of jobs friends would appreciate having you do. There are many ways to be generous without spending money.

·         Start a child care cooperative. Co-ops provide free child care in exchange for you taking a turn at caring for the children.

·         Look into freecycling programs in your community. Freecycling is when a person passes on, for free, an unwanted item to another person who needs that item. The Freecycle Network online at freecycle.org can help you find local resources.

·         Make gifts. Grow plants from seeds or cuttings to give as gifts. Fill an inexpensive basket with loaves of fresh bread. Develop a unique, quality craft to use as a gift. Gifts do not always have to mean an expensive purchase.

·         Trim your children’s hair between professional cuts. Better yet, you may be able to give simple cuts yourself.

·         Choose an easy-care hair style - you’ll need fewer styling products.

·         Evaluate your need for cable television services. How much time do you really spend watching cable stations, and how important is that to you and your family?

·         Write more letters or e-mails if you have access to a computer, or make fewer long-distance calls. The cost of a stamp is usually less than long-distance rates.

·         Check through your telephone and cell phone bills carefully each month to be sure all the calls you are paying for are correctly billed.

·         Cancel any phone services you are paying extra for but don’t really need (call waiting, call forwarding, text messaging, etc.).

·         When you must use long-distance, make your calls when the rates are the lowest. If you use a cell phone, call when minutes are free.

·         Take advantage of learning opportunities at local schools, attend University of Missouri Extension classes, community-sponsored workshops and other adult education courses. All of these can increase the skills and knowledge you have to work with.

 

Housing

·         Rent, share or borrow household equipment that is seldom used.

·         Simplify your possessions. Get rid of anything you’re not using to save on cleaning, maintenance and repairs.

·         If furniture or appliances are needed, check the classified ads in the newspaper or try an auction, garage sale or secondhand shop.

·         Learn how to refinish furniture. Refinishing takes skill and time, but is an inexpensive way to acquire attractive furniture.

·         Maintain your home. Make minor repairs before they become major ones requiring an expensive financial outlay.

·         Learn to clean, repair and restore household items yourself. Substitute your time and skills for dollars you would have to pay to someone else.

·         Make your own draperies, curtains, spreads, slip covers and table covers. Look for instruction books at your library.

·         Cut down on cleaning supplies by buying all-in-one cleaners. You will have fewer dollars invested in cleaning supplies.

·         Follow instructions on amounts of cleaning products to use so there is no waste from using more than actually needed.

·         Wash walls instead of painting. Washing may be all that is needed to freshen the look of a room.

·         Install a water-saver shower head (available at most hardware stores). There will be water and energy savings, and family members may not even notice the change.

·         Take short showers instead of baths to save water. There will be additional savings from not having to heat the extra water.

·         Rent out a room or garden space for additional income.

·         Provide a room in exchange for child care or elder care.

·         Service your furnace yearly and change filters regularly. A well-maintained furnace with clean filters will operate more efficiently.

·         Turn off air conditioning and open windows in temperate weather. Consider installing an attic or roof fan, which costs less to operate than the air conditioner.

·         Stop watering the lawn. The savings on your summer water bill can be considerable.

·         Try energy-saving measures like placing plastic over single-pane windows in winter. Your furnace will not have to operate as much because there will be less heat loss.

·         Close rooms and turn off the heat or air conditioning to rooms not being used.

·         Use window shades or insulated drapery liners to block sun in summer and drafts in winter. You will be more comfortable and spend less on heating and cooling your home.

·         Contact your utility company to have an expert check the insulation in your house to make sure it is adequate. If it’s not, insulate where needed. Insulate open areas, like the attic, yourself. Proper insulation provides long-term savings on your energy bill because the furnace and air conditioner will not have to run as often.

·         Replace incandescent light bulbs with compact fluorescent light bulbs where possible. This is especially helpful in rooms where lights are left on for long periods of time.

·         Turn off lights, TV and appliances when they are not in use. It  saves on energy usage and will help the appliances and light bulbs last longer.

·         Adjust your thermostat setting in both cold and hot weather. For every degree adjusted, you can save 1 to 3 percent on heating and cooling costs. When in the house, dress appropriately for the adjusted temperature.

·         Save energy and money by turning down the hot water heater. A setting of 110 degrees F to 120 F is adequate if you do not have a dishwasher, 140 F is recommended if you do have a dishwasher.

·         Whenever you must buy equipment, study the Energy Guide labels that compare estimated annual operating costs. The label provides information on the average cost of operating that specific appliance annually.

 

Managing money

·         Keep track, item by item, of where your money goes every day, week and month. Go over this spending record periodically with the entire family. Decide together if money is being spent the way you really want.

·         Do not carry more money than you can afford to spend. You can’t buy impulsively if you have to return to make the purchase.

·         Check to see if you are eligible for specific income tax credits. Certain federal tax credits can provide a larger tax refund or can cut the amount withheld from each paycheck.

·         Have a garage sale to get rid of unwanted items. This frees up storage and generates money for other needs.

·         Stay away from malls. It’s too easy to spend money on impulse when browsing at a mall.

·         Analyze your insurance coverage to make sure you are adequately insured at the lowest price. Comparison shop for insurance. The cost for the same coverage can vary widely from one insurance company to another.

·         Take advantage of community recreation services like concerts, fairs and public tennis courts.

·         Consider taking up less expensive sports and hobbies than you have now. There are many ways to have fun at little or no expense.

·         Pay bills early when creditors give a discount for early payment.

·         Balance your checkbook soon after the bank statement arrives to stay on top of your finances - overdrafts can be expensive.

·         Read magazines and books from the library. Cancel book club memberships and magazine subscriptions, especially for those that remain unread for a long time. Look for ways to enjoy the same resources at little or no cost to your family.

 

Brenda Procter, M.S.

Consumer & Family Economics Extension Specialist

MU Personal Financial Planning Department

162 Stanley Hall

Columbia, MO  65203

Phone:  573-882-3820/5115

Fax:  573-884-5768

ProcterB@missouri.edu

 

http://extension.missouri.edu/hes/poverty.htm 

http://missourifamilies.org

 

Wednesday, January 11, 2012

Investing versus Gambling

I read the other day that the price of Powerball ticket is increasing from $1 to $2 on the 15th of January.  So, for the same expenditure, lottery ticket purchasers will get half as many chances to win or, if they want to maintain a pattern in number of tickets purchased, they will spend twice as much for the same number of tickets.  The good news is that the chances of winning are actually going to increase, as the lottery commission is reducing the number of red Powerballs by four, to 35, and increasing the second prize to $1 million, up from $200,000.  Why do people want to play the lottery?  Why are some players habitual players, while others are only occasional recreational players.  A sad indictment is that lotteries have been shown by research to be an inferior good, where more tickets are purchased, the lower the income of the purchaser.  Maybe they just don’t know any better or maybe they are really desperate. 

 

The payout on Powerball remains at 50% of the funds from the sale of lottery tickets, so lottery players will continue to expect to receive $0.50 for every $1 of tickets purchased.  The overwhelming majority of lottery “players” lose everything they spend on lottery tickets, yet they fantasize by buying tickets in the hopes that their financial lives will change.  There are even lottery ticket purchasers who claim to be “investing” in the lottery when they buy a ticket, with the knowledge that they only expect to receive half the price as a return from their “investment”.   Many people, in fact, buy lottery tickets like some of us save for retirement, through dollar-cost averaging.  When we dollar-cost average into retirement savings we purchase more, say, mutual fund shares when prices are lower and less when prices are higher, by making the same periodic investment.  If the market rises over time, we are assured that we will have more money at the end of our investing cycle than the principal we put in.  Lottery ticket dollar-cost averaging purchasers buy the same dollar amount of tickets each week with relative certainty that they will get half the money back.  Is this extreme fantasy or simply quiet desperation to hope to be the one in 195 million players to win the jackpot.

 

The gambler and the investor are linked, however, as both are driven by the amount they are gambling/investing and the “action” they receive from the process.  Those driven by the action will put more money into the game, as they are excited by the game.  It is curious, however that when a stock sells at a high, say a three digit (APPL) or six digit price (BRK-A), investors shy away from the stock.  The high price, relative to other stocks, causes many investors to be reticent to buy the stock as it is high priced.  Those same investors might be willing to purchase low-priced, “penny stocks” in the hope of finding a hidden gem.  Neither the investor nor the gambler is rational, if they continually spend/invest large sums of money on low probability events.  The cumulative value of losses in these “investments” can be quite large.

 

When lottery tickets were just becoming commonplace, I heard a financial planner call them a “tax on stupidity”.  Given the wide gap between the cost and the expected value of the payout, why would anyone buy a lottery ticket?  Perhaps, some people simply enjoy paying money to others so they can lose their money.  It is not, however, the path toward financial success.  I have read that one in ten British citizens believe that they will win the lottery to pay for their retirement.  That is not a retirement plan.  Rather, periodic dollar-cost averaging, across a lifetime of saving and investing in a diversified portfolio designed to reach financial goals is financial planning.  And, guess what, you will become a millionaire.  Now that you understand more about the lottery, you can see that lotteries really are a tax on stupidity……. those lacking your understanding.

 

Thursday, January 5, 2012

What do Financial Market Indicators Tell us?

Each month the Federal Reserve Bank of St. Louis publishes a newsletter titled Liber8, which is a selection of useful economic information, articles, data, and websites compiled by the librarians of the Federal Reserve Bank of St. Louis Research Library. This month the article is about financial market indicators. If the financial lingo you hear reported on the news doesn’t seem to make a lot of sense, this issue should help you understand it better. We encourage your comments and thoughts at http://mufinancialtip.blogspot.com.

 

There is a classroom version of Liber8 available to teachers for free at: http://liber8.stlouisfed.org/newsletter/2012/Lib0112ClassrmEdition.pdf

 

To subscribe to their newsletter or for more information and resources, visit their website and archives at http://liber8.stlouisfed.org.

 

The views expressed are those of the author and do not necessarily reflect the official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, the Board of Governors, the University of Missouri, the Personal Financial Planning Department or The Office for Financial Success.

 

By Linpeng Zheng, Research Associate

Financial market data are reported daily in the news—usually as prices, indexes, or interest rates. While these data provide direct information (e.g., a Treasury bill pays 2 percent interest), they also give some indication of future economic growth, inflation, and financial market stability. Changes in these data can also affect decisions about consumer spending, educational loans, and retirement plans. Financial markets are important in everyday life because making good business decisions is difficult without understanding how key financial indicators behave. Popular financial indicators usually fall into four categories: commodity prices, stock indexes, interest rates, and yield spreads (the difference between two interest rates).

We start with the simplest financial indicator—commodity price. Various commodities (e.g., corn, gold, oil) are traded on commodity exchanges, much like the stock markets for individual stocks. If an airline wants to purchase 1,000 barrels of oil today, it needs to pay the current price, which is called the spot price.[1]

However, if the airline company wants to purchase 1,000 barrels of crude oil for delivery next year, then it can sign a contract at a fixed price today for the oil it will buy next year; this price is called the futures price.

If some event reduces the future supply of oil, which may increase the spot price at a certain time next year, the airline will pay only the locked-in price specified in the futures contract. Hence, this lower futures price reduces the oil expense for the airline. Futures prices are affected by various factors, such as the spot price, storage costs, and interest costs.

The most common financial indexes refer to the prices of the stocks of publicly traded companies. For example, the stock price of Microsoft was $25.76 on December 12, 2011. Other than individual stock prices, an aggregate stock price index also plays an important role. For instance, the Standard and Poor’s 500 (S&P 500) is a market value-weighted[2] stock price index of 500 stocks chosen based on market size, liquidity, and industry. It covers various industries in the entire U.S. economy. If investors plan to allocate their funds to equity markets, they likely will pay attention to two factors: the prices of the stocks of individual companies and the prices across the broader stock market, as measured by indexes like the S&P 500.

Stock prices generally increase or decrease as a result of changes in expected future earnings. If a company’s new product launch is viewed positively by the market, the stock price of that company may rise. On the other hand, movements of aggregate stock indexes tend to signal changes in the state of the macroeconomy: Good economic news should increase the earnings of many companies. For instance, the S&P 500 may increase after better-than-expected job growth. Similarly, a sequence of bad economic news causes investors to lower their profit forecasts for firms. Thus, the S&P 500 is one of the most closely watched stock indexes because it incorporates new information about the future health of the economy. Just as stock price indexes cover equity markets, interest rates determined in the bond markets are also important.

An interest rate is simply the price of borrowing money for a fixed period. In the United States, the federal funds rate, which is importantly influenced by Federal Reserve monetary policy decisions, is one of the most important interest rates. It is the interest rate at which banks borrow money from other banks. In bond markets, interest rates are referred to as yields. Bonds with different maturities have different yields. It usually costs less to borrow for a few days or months than a few years because of a factor known as the term premium.[3] If borrowers expect projects to generate higher profits in the future, they may be more willing to borrow at a higher rate. But interest rates can also be influenced by other factors. For example, if inflation is expected to be higher in the future, creditors or investors tend to require higher yields to compensate them for the inflation risk they incur.[4] As a result, the nominal interest will increase. Thus, bond yields also convey information about future inflation and economic growth. In addition to Treasury securities, corporate bonds are also important financial indicators. Corporate bonds have letter designations (e.g., AA+, B+) that represent the quality of the bonds (i.e., the risk of borrower default).[5] Lower-quality bonds tend to have higher yields to compensate investors who are willing to take more credit risk. A corporate bond is considered investment grade if its credit rating by rating agencies is “BBB” or higher.[6]

Now that we know what yield is, let’s talk about yield spread. The yield spread refers to the difference between the yields on two different bonds. Popular spreads are those derived from yields of Treasury bonds of different maturities (i.e., the term spread) and of corporate bonds with different credit risk (i.e., the credit spread). First, the term spread on Treasury securities—the difference between the yield on a 10-year Treasury bond and a 3-month Treasury bill—is frequently mentioned in the news as the yield curve[7]: When the yield curve slopes downward, future short-term interest rates are expected to fall because investors generally believe the economy will weaken or fall into a recession. The second type of spread—the credit spread—can also increase or decrease because of changes in the possibility of default risk. For instance, when credit spreads widen, it implies that the market is factoring a higher risk of default on lower-quality bonds, which may occur during times of financial distress.

 

Ryan H. Law, M.S., AFC

 

Personal Financial Planning Department

Office for Financial Success Director

University of Missouri Center on Economic Education Director

 

239E Stanley Hall

University of Missouri

Columbia, MO 65211

 

573.882.9211 (office)

573.884.8389 (fax)

 



[1] The spot price of oil contains information about the current demand and supply of oil conditions.

[2] A market value-weighted index is an index whose components are weighted according to the total market value of their outstanding shares.

[3] Investors need the extra compensation for locking up their money for a longer period

[4] Unexpected high inflation will hurt creditors if the dollars paid back to them are worth less than the dollars lent.

[5] U.S. government Treasury securities are also rated by credit rating agencies, such as Standard & Poor’s or Moody’s.

[6] Some institutional investors (e.g., pensions) will invest only in AAA-rated bonds based on S&P’s credit rating standard. Bonds with ratings below “BBB” are collectively called junk bonds.

[7] This is because the slope of the yield curve can be approximated as the term spread between the 10-year Treasury security and a 3-month Treasury security.