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Your Bond Income Could Be an Illusion

One of the saddest messages I am most often required to deliver to new clients is that their bond income is merely an illusion, and a tricky one at that. In fact, in most cases, their actual income is a tiny fraction of the amount shown in their brokerage statement. If you own individual bonds (not bond funds), this is probably happening to you as well — and costing you dearly. And this can occur indefinitely without your ever noticing.

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To better understand this, I’ll use an example of a consumer who came to me recently with a brokerage statement showing she was getting 3.5 percent in tax-free income from a municipal (muni) bond portfolio worth about $300,000. The brokerage statement showed about $10,500 in tax-free income, all from highly rated municipalities. This happens to be roughly twice the yield  of low-cost municipal bond funds from companies like Vanguard and Fidelity. The first clue is that anything that looks too good to be true usually is. In reality, her income was roughly $3,000, or only about 1 percent.

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Behind the curtain

Here’s how the illusion is performed, using one bond as an example. The broker buys a bond that will mature in three years and pays a price of $112. The $12 over the $100 price is known as a premium over the bond's $100 par value. This bond paid a $5  coupon (annual payment) for each $112 invested, and the statement shows a current yield for this particular bond of 4.46 percent, which is calculated by dividing the $5 coupon by the $112 price.

Bonds, however, mature at a $100 par value, so this investor will get back only $100 for each $112 invested. Thus, she will lose about $4 per year over the three-year period. This means that roughly $4 each year of every $112 invested, or about 3.57 percent of the 4.46 percent current yield, was just the return of her own money, leaving her only about 0.89 percent of actual income.

Unfortunately, the illusion isn’t over yet. The brokerage firm also charged the client about 0.7 percent annually to manage this bond portfolio. So deducting the 0.7 percent from the remaining 0.89 percent of actual income before fees leaves only about 0.19 percent for this investor. That’s barely more than a tenth of the true yield of a low-cost municipal bond fund, which is required to show the yield after fees and excluding return of your own principal. The illusion for this particular bond reveals that the stated 4.46 percent current yield was actually just 0.19 percent.

I sent this particular statement to the Municipal Securities Rulemaking Board (MSRB), which is the self-regulatory organization over the municipal bond market. The board declined to comment on it specifically, saying only that “additional education for investors on customer statements could be helpful, and it is in our work plan for this year.”

How to protect yourself

If you own individual bonds, whether taxable or tax-exempt municipal bonds, take a look at your most recent statement. Ask your broker or a representative of your brokerage firm whether your “income” includes any “ amortization of premium.” This is a fancy term for return of your own principal. The illusion gets even more complex if the bond has a call feature, which gives the issuer the right to pay off the bond at par early.  So ask for what’s called the yield to worst, which is the yield you will likely get given today’s interest-rate expectations of the market.

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Next, ask whether you are paying any other fees, such as management fees, and ask what your net return amounts to after all fees and amortization of premium.

Because this illusion isn’t allowed by the mutual fund industry, consider low-cost bond funds as alternatives. Always try to keep fees below 0.3 percent annually ($3 for every $1,000 invested) — the lower the better. These bond funds also provide diversification by owning thousands of bonds, rather than a handful, as well as a professionally managed portfolio of bonds.

Photo: iStock/SPXChrome

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