Liability management strategies for any rate environment

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1 Liability management strategies for any rate environment April 2015 We ve all seen the headlines trumpeting an inevitable rise in interest rates. The conventional wisdom accepts that, after years in record-low territory, rates have nowhere to go but up. Savvy investors, however, know that the conventional wisdom does not always tell the full story. Changes in interest rates are impossible to predict, and they are not a one-variable equation. Rates rarely move in lockstep for long-term and short-term debt. What s more, different fixed income and debt solutions will be affected in different ways by interest rate trends. As the interest rate jitters intensify, some investors are thinking about adjusting their fixed income portfolios in preparation. By focusing solely on their assets, however, they are overlooking the other side of their balance sheet. Liabilities, or outstanding loans, are a crucial part of an investor s overall financial picture. Smart liability management can help you reach long-term investment goals while meeting shorterterm needs regardless of what interest rates do in the next year or two. Interest rate trends: What to watch Prepare for rate hikes An improving economy and strengthening dollar mean that rates may finally rise and investors should be prepared. Though rates will likely not rise immediately in 2015, three-month Treasury bills will likely be a top performer if the Fed starts to tighten. Rate increases will likely be gradual given weak overseas growth and low inflation in the U.S. Rate increases will translate into higher borrowing costs, most immediately for variable-rate credit lines. Interest rate rate forecast summary (As (As of March of April 10, 3, 2015) (% EOP) 1Q15 2Q15 3Q15 4Q15 Fed funds month T-bill month LIBOR year T-note year T-note year T-note year T-bond Source: BofA Merrill Lynch U.S. Rates Research. Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated, a registered broker-dealer and Member SIPC, and other subsidiaries of Bank of America Corporation ( BofA Corp. ). Banking products are provided by Bank of America, N.A., and affiliated banks, Members FDIC and wholly owned subsidiaries of BofA Corp. Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value

2 The importance of a systematic approach to liabilities Most Americans hold some form of debt, and therefore may be affected by changes in interest rates. The most common liabilities are mortgages, credit card balances, car loans and student loans. As you make regular monthly payments on these loans, it is important not to lose sight of the bigger financial picture. By considering your assets and liabilities together, you may be able to better position yourself to achieve several important goals: Gain access to the liquidity you need for short-term goals and unexpected expenses Leave your longer-term investment strategy intact so that your wealth has the potential to continue to grow Position yourself for potential changes in interest rates Balance the maturities of your assets and liabilities in order to fund debt and pursue growth Our liability management process Merrill Lynch recommends a four-step process to manage your personal liabilities: 1. Determine your outlook for interest rates and the markets 2. Prioritize your short- and long-term financial goals 3. Understand the features and terms of all your liabilities 4. Create a strategy that incorporates your liabilities into your goals-based wealth management process Step 1: Work with your financial advisor to determine your outlook Your outlook on markets and interest rates will have an impact on how you borrow and invest. It is important to recognize that short-term and long-term rates respond to different factors and can move independently of each other. If rates on your short-term loans start to rise, you should consider why they re rising before deciding to pay off the loan. If rates are heading higher because the economy is strengthening, the assets supporting the loan may be appreciating as well. If, for example, you have a loan that is supported by your investment portfolio, selling those securities to pay off your loan could mean missing out on potential future market appreciation. This is referred to as opportunity cost. Short-term interest rates are affected by changes the Federal Reserve makes to the federal funds rate as it strives to accomplish its monetary goals. Moves in short-term rates will have an effect on variable-rate loans. Long-term interest rates generally move in step with the rates for Treasury securities. Treasury rates reflect factors such as the pace of the economy, supply and demand in the debt markets, and inflation expectations. These rates tend to have an impact on longer-term loans such as mortgages. Most news stories about interest rates usually focus on the 10-year Treasury yield, but this usually has a limited effect on the average investor. It is more likely that you hold short-term revolving debt, which tends to track the three-month London Interbank Offered Rate (LIBOR) or the federal funds rate. As rates begin to rise in later 2015, we may see upward pressure on LIBOR, but it will likely be slow in coming. Think like a corporate CFO Most companies carry some form of debt as part of their business plan. They seek to ensure ready access to credit well before they need it. Investors can benefit from thinking like a corporate chief financial officer about their personal liabilities. Just as a CFO does, you should look objectively at the cost of your debt to determine which liabilities to reduce and which make good business sense to maintain. View your balance sheet as if it belongs to a thriving company, and use your borrowing power to meet cash flow needs rather than liquidating assets. You can also consider the maximum interest rate you might need to pay on each loan to determine whether a different financing vehicle might be more cost-effective. Assets Liquid assets (e.g., money market funds, CDs) Investment assets (e.g., stocks, bonds) Tangible assets (e.g., real estate) Source: Merrill Lynch. Liability management focus Personal balance sheet Liabilities and equity Short-term liabilities (e.g., credit cards) Long-term liabilities (e.g., mortgages) Net worth 2

3 Evaluate interest rates in the context of your particular situation If you have fixed-rate debt If you have loans you intend to hold for the long term, but you re paying a short-term or revolving rate If you re thinking about paying off debt now If you re thinking about taking on new debt Your rate for a 15- or 30-year mortgage is probably locked in, so a rise in rates won t affect you. But if rates decrease, you might have an opportunity to refinance. That could cause a mismatch in your liabilities. There may be ways to better align this debt with its time frame, even though our firm does not expect short-term rates to rise in the near future. There may be smarter strategies, such as an interest rate swap, that can help insure you against rising rates. Or you may be able to use that cash to take advantage of market opportunities rather than eliminating the loan. Establish an outlook for the asset you hope to purchase what will it cost if you wait to buy it? Weigh that against the potential cost of the loan and your ability to service the debt. Your financial advisor, backed by the thought leadership of BofA Merrill Lynch Global Research, can help you understand key drivers of rate changes. Our firm s top strategists frequently publish their insights about the interest rate puzzle. Armed with these resources, you can formulate an opinion on interest rate forecasts and consider how they might affect the different loans you hold. Step 2: Prioritize your goals You have already spent time with your financial advisor going through our goals-based wealth management process. When you articulated your needs and goals, you may have focused on longer-term plans. But liability management is another key aspect of the process. Think about your plans in terms of shorter-term cash flow needs as well as medium- and long-term objectives. The figure to the right shows some sample goals, grouped by time frame. This exercise allows you to assess your liabilities by comparing the time frame of each need with the duration of the related debt. Questions that can help you get started include: How many more years do you plan to work full-time? Do you have any high interest rate debt that you want to reduce? Do you plan to buy a vacation home? Do you need access to liquidity but don t want to trigger the taxes associated with selling your concentrated stock? How will you meet any unexpected expenses that might arise? Do you anticipate moving or downsizing your home in retirement? Is there a charitable organization you would like to support in a meaningful way? Do you need extra liquidity to pay taxes this April? Do you foresee any large purchases or major milestones on the horizon? Your borrowing temperament is another important aspect to consider when determining your priorities. Some individuals are simply more comfortable with debt than others. They will tend to approach their investments and liabilities differently from those who want to pay off their loans as soon as possible. Short-term goals Renovate kitchen Meet unexpected needs such as home repairs or medical bills Fund college education Consolidate debt into one lower-rate loan Medium-term goals Pay for a child s wedding Take advantage of retirement catch-up provisions Sell current home and retire to a southern state Purchase a sailboat Long-term goals Generate retirement income Fund rising health care costs Help children get a first mortgage Leave a legacy to children and grandchildren or favorite charity 3

4 Step 3: Understand your liabilities The next step is to update your personal balance sheet in order to get a full picture of your asset-to-liability ratio (see the worksheet below). This is the relationship between what you own and what you owe. Conduct a thorough review of the terms and rates of all your outstanding debt, including mortgages, home equity lines of credit, credit card balances, auto loans, boat loans and any others. Ask yourself what the purpose is for each outstanding loan or for a potential loan that you are considering. Review the terms of each obligation to verify whether the rates are fixed or floating and whether that dovetails with your rate outlook. Quantify your current liabilities that is, shorter-term debt such as credit card payments, which are typically paid off in less than a year. And add up your long-term liabilities, such as mortgages and other notes with terms longer than one year. The grid below can help you consider all the salient features of your current debt in one place. Next, determine how much liquidity you have access to through both secured and unsecured forms of debt. This includes credit card limits, untapped lines of credit and potential securitiesbased loans. It is useful to be aware of your borrowing power, particularly if it allows you to avoid selling assets to meet liquidity needs. As corporate CFOs know, not all debt is problematic. Other questions to consider in your liability review include: How do you intend to service and eventually pay off your debt? How will you fund future needs, aspirations and opportunities? Step 4: Create a strategy Once you understand your assets and liabilities, you can work with your advisor to decide how much cash to hold to meet dayto-day needs and discuss your goals to gain a clearer picture of the liquidity you may need over the next few months or years. By thinking like a smart CFO, you can take steps to establish the liquidity you need before you need it. The confidence of knowing you are prepared for unexpected expenses can have a significant impact on your ability to stick with your investment strategy and can help you pursue your longer-term goals. You may decide to consolidate your outstanding debt to obtain more attractive rates and simplify management of your payments. It may be possible to refinance your mortgage and any other long-term loans to better reflect your interest rate outlook. Your financial advisor is available to help you create a strategy that takes into account your entire balance sheet and to help integrate liability management into your overall wealth management strategy. Conclusion Much like that of a large corporation, your personal balance sheet should include strategic liabilities and ready access to credit. In an environment that may bring changes in interest rates, it is worthwhile to revisit your liabilities and ensure that you are being systematic about them. That said, the existence of debt on your personal balance sheet is no cause for alarm. Though our firm expects some interest rates to rise, it is likely to happen in a gradual and modest way. Your financial advisor can help you evaluate whether what you re reading in the news really applies to you. Together, you can consider that information in the broader context of your own particular situation. Take a step back from the headlines and speak with your advisor about managing both sides of your personal balance sheet. Merrill Lynch recommends a four-step process that can position you to strategically manage your liabilities no matter what interest rates and markets may do. Incorporating a balance-sheet approach into your goals-based wealth management strategy can help keep you on track to pursue your long-term goals. Talk to your financial advisor to learn more. My liability management worksheet Loan type Balance Interest rate Fixed/variable Term/reset date Monthly payment 4

5 Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy Bank of America Corporation. All rights reserved. ARSRC499 SHEET PM /2015

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