BOND INVESTORS' FORUM More
Previous 1 2 3 4 5 6 7 8 Next
No waiting
I have just discovered your Web site today and have found it extremely
informative and valuable. I am a 56-year-old male and have been
retired living off the interest of my bonds. I was going with a
strategy of buying callable agency bonds. In the past several years,
everything got called on me and rather than sitting, I bought long-term
agency 's with call features. Thought that I had done the wrong
strategy, but your articles made me feel a lot better. I was going
to sit and wait for rates to go higher, but figured I could ride
the higher rate until call, and if they didn't call, it wouldn't
be the worse thing either. Thanks again.
R.L, Ohio
04/27/04
Tobacco bonds revisited
I would like to know your view of the creditworthiness of tobacco
settlement-backed municipal bonds? I am aware of the credit ratings
on these bonds, but would also like to know your view of the probability
that these bonds, especially the longer-term issues with final maturities
of 2033 and beyond, will not default.
K.C., Iowa
03/30/04
Treating capital gains on premium and discount bonds
If I have read your Bond Forum questions and answers correctly,
municipal bonds bought at a premium cannot be recorded with a capital
loss for income tax purposes when called or matured at par, but
municipal bonds bought at a discount must be recorded for income
tax purposes as having a capital gain when called or matured at
par or above. Is this correct? When FMSbonds shows the yield-to-call
or yield-to-maturity for bonds purchased at a discount, you cannot
be including in those yields the capital gain to be incurred for
call or final maturity at par or greater, because to do so you would
have to know the tax bracket of the purchaser, correct?
K.C., Iowa
03/30/04
Mr. Klotz responds: Your thoughts are correct
regarding the capital gains tax-treatment of premium and discount
bonds. Any yields on discount bonds displayed on our Web site are
"before tax" yields.
We would not offer any bonds to our customers if we thought there
was a probability of default. We do, however, caution investors
about the potential for volatility in these tobacco issues. Many
investors feel the additional income they receive from tobacco bonds
adequately compensates for the increased volatility in the marketplace.
Most long-term tobacco bonds are not expected to be outstanding
at their final maturity.
If you click on one of these offerings the "bond detail"
screen will note the anticipated "average life" for the
bonds.
Tobacco bonds are expected to have shorter average lives because
of their accelerated payment structure.
Yield calculations
I agree with your remarks about "market timing." I've
tried that in the past without too much success. However there is
a question I would like to raise: You describe a muni bond that
has a 4.75% yield that is comparable to a 7.30% yield for those
in the 35% bracket. Why do you assume everyone is in that 35% field?
What are the yields if one was in the 30% or 25% bracket? How much
of a difference is there?
D.P., Florida
03/17/04
Mr. Klotz responds: Your point is well taken.
Not everyone is in the maximum tax bracket. Today's tax-free bond
yields are also attractive to investors in the 25%, 28% and 33%
brackets.
Here is the formula for determining taxable equivalent yield:
First, determine your tax bracket. Then divide the reciprocal into
the tax-free yield you are evaluating. (You will find the reciprocal
by subtracting your tax bracket from 100.)
For example: If you are in the 25% bracket, divide the 4.75% tax-free
yield
by 75 (4.75 / 75 = 6.33%).
In the 28% tax bracket divide 4.75% by 72 (4.75 / 72 = 6.60%).
Amortizing the premium
I am interested in premium bonds, but I have been unable to determine
how I would treat the premium if the bond is called prior to maturity.
I realize that the premium would need to be amortized, but I have
not been able to determine the date I would amortize the premium.
I am wondering if it should be amortized to the maturity date, the
first call date or some other date. I have called several brokerage
firms and have gotten different answers. I have also called the
IRS and, after speaking to two different people, I was told that
it specifies the maturity date as the date to use for a taxable
bond but does not specify a date for a non-taxable bond.
My concern is that if I purchase a premium bond that has a maturity
date 10 years out, I know that I must amortize one tenth of the
premium for each of the years giving me a basis of 100 when the
bond is redeemed.
If I amortize to the maturity date even if the bond is called,
then I would still have one half of the premium to use as part of
the basis. If, however, the bond would have to be amortized to the
call date (in, say, five years) the premium would have cost a lot
more than was anticipated. Also, if a bond has to be amortized to
a call date, which one would be used? There are many times when
a bond has an early call date at a premium and then will have various
periodic call dates at par. If a bond has to be amortized to the
call date that is executed, then it means that all of the premium
would have been used and the basis would always be 100.
As I see it, unless an investor knows the time period that the
amortization of the premium will cover, then it would be impossible
to determine if the premium bond is an investment which will truly
give more yield.
F.M., Pennsylvania
03/04/04
Mr. Klotz responds: Your point regarding
the confusion attendant to amortizing the tax-free bond premium
is well taken. Over the years, we also have received conflicting
information on this subject from various tax preparers as well as
the IRS.
Although we are not qualified to give tax advise, we rely on the
U.S. Master Tax Guide published by the Commerce Clearing House (CCH),
which states: "No amortization is allowed for tax-free bonds.
However, reduction in the basis of the bond by the amount of the
bond premium is required." We suggest you consult with your
own tax professional for a definitive answer.
We disagree with your thought that knowledge of this tax treatment
at the time of purchase is necessary to determine how much yield
the bond provides, since every dollar invested, including premium
dollars, is factored into the yield calculations.
A premium and the yield calculation
A bond priced at 103 has got to have a significant yield to allow
for the $30 premium. If that bond matures at par, then a loss can
be recorded on form 1040. If called at 102, that would soften the
blow and all bets would be off. I like par bonds or discounters
with an eye on quality and yield best of all.
J.D., Ohio
03/04/04
Mr. Klotz responds: Your comments seem to
reflect some misconceptions regarding premium bonds. Let’s
start with your example of a bond priced at 103.
The $30.00 premium your mention is already factored into the yield
calculation of the bond. Every dollar invested (including the premium
dollars) is working at a minimum of the "worst case" yield
of the bond. For this reason, when the bond matures at 100, you
are not entitled to record this event as a capital loss for tax
purposes.
Although you say that you prefer 100 or discount bonds, you might
want to reconsider your approach with this information in mind.
Also remember, most discount bonds are subject to capital gains
taxes.
For more on premium bonds, scroll down and see are comments under
“Taking advantage of higher yields,” “What to look
for in premium bonds” and “Focus on yield when looking
at premium bonds.” You may also want to review our commentary,
“Finding value
in this market.”
Long-range planning
The final outcome of an investment cannot be judged until the investment
is sold. And even then a decision on these results is Monday morning
quarterbacking. Whatever the winning scenario is, an opposite one
can be hypothesized by citing actual historical events. Only a crystal
ball can choose the optimum options consistently. After this, all
is a crapshoot.
S.B.
02/25/04
Mr. Klotz responds: Your point is well taken
that certain evaluations regarding past investments can only be
made when an investment is sold.
On the other hand, a decision not to invest can be analyzed as
well. It is reasonable to assume that income investors who waited
for higher rates when they could have bought quality tax-free bonds
yielding 5.75% to 6.00% made a mistake.
Income investments are often never sold and are properly evaluated
by the income produced on an ongoing basis.
Opportunity or aberration?
I am not an experienced bond investor, and this question is asked
for general background knowledge rather than as a trigger question
for a specific investment.
As you know, when Orange County went into default several years
ago, the
value of its bonds fell. That included pre-refunded bonds, even
though they are backed (in most cases) by Treasuries, and (absent
shenanigans in the legal structure, which should be weeded out by
rating agencies) are free of default risk. Some investors bought
discounted pre-refunded Orange County bonds after the default, and
were rewarded when they collected full value for the bonds at a
later date.
Such opportunities may arise again in the future, at the state
or local level. Could you comment on this nominally risk-free strategy
for gains in bond investing? Would such a strategy apply both to
pre-refunded bonds and those escrowed to maturity?
W.S., Arizona
02/25/04
Mr. Klotz responds: Adverse publicity can
result in strange occurrences. In the wake of the Orange County
debacle, if certain pre-refunded bonds traded at lower prices, they
weren't significantly lower and the opportunity was short lived.
As you mentioned, pre-refunded and escrowed bonds are actually
secured by the full faith and credit of the U.S. Government and
are no longer considered to be debt of the original issuer.
The situation you described is more likely to occur with insured
bonds of a troubled issuer rather than with bonds backed by U.S.
Treasury securities. If someone told us they bought escrowed securities
at significant discounts during the Orange County crises, we would
be extremely skeptical.
Either way, we don't think that waiting for a financial crisis
to occur and hoping investors throw the baby out with the bath water
qualifies as a practical investment strategy.
Taking advantage of higher yields
When buying a premium bond, I end up investing more money up front
than the principal amount due at maturity. If I end up with less
capital money on the bond's maturity date than what I've invested,
why is buying a premium bond better than buying a par or discount
bond?
C.V., Washington
02/25/04
Mr. Klotz responds: The most important factor
to consider when investing in municipal bonds is yield.
Yield to maturity and yield to call indicate the rate at which
your investment dollars are working. Premium bonds typically provide
higher yields than comparable quality par or discount bonds. The
reason is quite simple: too many investors focus on dollar price
rather than yield and are averse to buying bonds priced above par.
Often, they erroneously perceive the premium as a penalty.
The premium price is not a penalty. It merely reflects that the
bond was issued at a time when interest rates were higher.
More than likely you have premium bonds in your portfolio that
at one time traded at 100.00. If you decided to sell AAA 7.00% bonds
purchased at 100.00 five years ago, they would command a premium
price, since comparable quality bonds issued today carry interest
rates of 4.50% to 4.75%.
Individual investors are a major factor in the municipal bond market.
Because they are often uncomfortable paying above par, dealers are
compelled to offer more yield when selling bonds to the investing
public.
We are simply suggesting that investors take advantage of these
higher yields. Keep in mind that every dollar invested, including
the dollars paid above par, are accounted for in the yield calculations.
Premium bonds also provide larger interest payments (more tax-free
income) than par or discount bonds, producing greater cash flow
for reinvestment.
Remember: focus on yield, not dollar price. Make sure the yield
to the call is acceptable since premium bonds are more likely to
be called by the issuer. As you begin to compare the yields on premium
bonds to par bonds issued today, the relative value becomes increasingly
evident.
Individual bonds for buy and hold strategy
Thank you for your excellent site. My spouse and I have recently
purchased $20,000 in closed-end California municipal bond funds.
We live in California, want tax-free income and are considering
investing another $20,000. The yields from these funds are very
attractive. Our tax bracket means we are earning the equivalent
of more than 9%. And that's what concerns me.
What is your best guess as to what will happen to tax-free muni
bond funds when interest rates begin to rise? It seems to me that
the managers of these bond funds would continue to acquire intermediate
and long-term bonds – at the higher rates – and therefore
the yield would remain comparable. Is my thinking sound? Can you
provide additional information to help me further understand the
risks we might be taking with these bond funds?
B.R, California
02/25/04
Mr. Klotz responds: The closed-end funds
you refer to are not pure municipal bond investments and we cannot
be certain how they will perform in a rising interest rate environment.
These funds employ leveraging strategies (borrow short term and
invest long term), which have served you well over the last few
years. If in the future, short-term interest rates rise faster than
long-term rates, the performance of these funds could be adversely
affected.
How will fund managers react to a higher interest rate environment?
Your guess is as good as ours.
When employing a buy and hold strategy, we recommend owning individual
municipal bonds if adequate diversification can be achieved.
What to look for in premium bonds
You imply that premium bonds are better values than those at par
because of individual investors' preference for par bonds. Are discount
bonds also a better value for the same reason? Why are premium bonds
more likely to be called?
R.C., Illinois
02/17/04
Mr. Klotz responds: Premium bonds provide
more value than par bonds because they typically yield more. The
reason for the more generous yield is that individual investors
shy away from bonds priced above 100.00. This is not true of discount
bonds, which carry prices that often look "cheap" to investors.
Premium bonds are more likely to be called because they carry nominal
rates (coupons) that are higher than the current rate on new issues
of comparable quality. This is why they trade above 100.00, and
this is why the investor must be conscious of the yield to the call
or "worst case yield."
I very much agree with your piece on, well, I'll call it the "Fed
readers and the difference between traders and investors."
I confess I spend a lot of time working with CNBC playing in the
background. But it is a form of madness to take most of what the
talking heads say seriously. Thanks for a good piece.
B.B., Illinois
02/17/04
A ladder that works
There seems to be a lot of interest in laddering. Some years ago,
I sold a house and I wanted to invest the proceeds in tax-exempt
bonds. The bond broker (not FMS) recommended a little ladder, and
I went along at that time. But after a while, when I had more money
to invest, I realized that I would be better off in the longer term
to get the most yield. In the interim, I found FMSbonds. As it so
happened, I had additional money to invest, so I bought the best
yield-to-maturity that I could find in the rating class I wanted.
I think the FMS offerings and the service are top notch.
Some of these bonds are shorter than others, but when I look over
the portfolio, I see that I have a big ladder with a bond maturing
in 2005 and every few years until 2032. I feel that when interest
rates rise, my maturing bonds will give me the cash to invest in
the higher rates. I don't worry about the price of the bonds I hold
because I don't plan to sell them and I can buy replacements as
they mature. The point is that if your bond purchases occur over
time, you are likely to wind up with a ladder of some kind and that
isn't so bad.
Personally, I think the best strategy for the individual investor
is not to obsess about moving money around between bonds and stocks,
but to decide where the plus-dollars (new money) coming into your
portfolio are going to go. If you are light on bonds, put the new
money in bonds until you feel you have enough. Then put the new
money in equities, closed ends, mutual funds, etc. When you are
satisfied with your equity position, then channel the new money
to the bonds -- or do it between bonds and stocks in some proportion.
At some point, when the portfolio is nicely filled with income-producing
bonds and good value equities, you will have excess cash to put
small bets on highly speculative instruments. Most investors do
this first with the bulk of their money -- and that's why so many
people lost so much when the bubble burst.
I think an investor's portfolio is always a work in progress. The
proportion of your allocation changes as you age. Your investment
choices are a balance between your income needs, risk tolerance
and time horizon.
I.S., New York
02/17/04
Bond values
Wouldn't the value of long-term bonds increase with time, regardless
of current interest rates? Let say I want to sell a 20-year bond
10 years from now. In that case, it really becomes a 10-year bond,
and presuming that the interest rate for a 10-year bond is lower
than that of a 20-year bond, doesn't it mean that I can then sell
my 20-year bond at a higher value than face?
M.L., Washington
02/11/04
Mr. Klotz responds: Your thoughts are correct
regarding bond values increasing as bonds move closer to maturity.
This is due to the "positive slope" of the yield curve.
Debtors pay a higher rate of interest for the privilege of borrowing
money for longer periods of time.
When your 20-year bond becomes a 10-year bond, it will be priced
relative to a new 10-year bond (lower yield). The dollar price,
however, may not necessarily be substantially higher than the face
value for a number of reasons.
Most new issues are callable by the issuer in 10 years. Bonds that
are imminently callable will not command a large premium. As bonds
move closer to maturity, increases in dollar price are limited by
the fact that they mature at 100.00. Conversely, in a rising interest
rate environment, the shorter maturity will limit downside risk
for the same reason.
The best feature of your bonds is that your income remains constant
as long as they are outstanding.
Closed-end funds
Thank you for your wisdom on muni bonds. I was impressed by your
recent statement that you will not get rich buying bonds, but you
will stay rich.
I have most of my money invested in closed-end bond funds, all
listed on the New York Stock Exchange. They pay 6% to 7% with distribution
every month tax free. When the market was tanking, my bond funds
appreciated 2% to 3% annually and paid an attractive return. I am
elderly and retired. I know that interest rates will go up –
my guess is that it occurs a year after the election – and
the price of funds will drop. If funds continue to pay the same
return, the price of the fund is of no significance to me because
I am not really interested in the value of the funds, but depend
on returns. Do you have any comment regarding the closed-end funds
of well-known companies such as Morgan, Putnam, Nuveen, Seligman,
etc.
G.P., Florida
02/11/04
Mr. Klotz responds: Let me preface my comments
by saying that our approach to municipal bonds is primarily purist
and old fashioned. The statement that you agreed with relates to
owning individual tax-free bonds, not funds. Our goal is to produce
a steady and dependable stream of tax-free income with no thought
of producing capital gains.
The goal of closed-end funds, which you own, is to produce attractive
annual total returns. These funds utilize leverage. Over the years
you have owned them, they have been able to borrow at very attractive
short-term rates to purchase additional income on longer-term bonds.
If we have a concern, it is our inability to predict the performance
of these funds if short-term interest rates rise.
Mutual funds also mitigate one of the best features of a bond:
a fixed maturity date. In higher-rate environments, holding your
bonds to maturity can rectify any market value declines. As interest
rates declined over the past few years, bond prices moved up. We
don't recommend selling them because the income can't be replaced.
We would guess that you have not taken profits on your funds for
the same reason. This is why we find total return (income plus appreciation)
to be meaningless – except in the marketing of bond funds.
Focusing on yield
Good article on holding muni bonds for the long term. However,
since I am 60 years old, with a life expectancy of 85 to 90 (I am
in good health), when is the best time to buy muni bonds, since
we are in a rising interest rate environment? My broker tells me
it doesn't make any difference if I pay over par for a bond; he
says the key features are coupon, yield and call date. I have a
ladder of muni bonds but here is an example.
I recently bought premium bonds. Since current bonds available
to buy at par are below these yields, does it make sense to buy
any muni bonds now since interest rates should be going up in 2005?
How can I buy muni bonds at par with good yields?
02/11/04
Mr. Klotz responds: In our experience, the
best time to buy municipal bonds is when you require after-tax income
and have investment dollars available.
As far as interest rates go, we have been in a declining interest
rate environment for the last 20-plus years.
Your broker is correct: premium bonds usually offer the best value
in the muni market. You should focus on yield, not dollar price.
With premium bonds, yield-to-call becomes more significant , since
they are more likely to be called than par bonds.
Bonds trading at 100.00 are reflective of the new issue market
and rarely represent the best values for the obvious reason that
par bonds are easier to sell to individual investors.
Both in business and in my personal affairs, it has been my practice
to maintain a balanced budget. It is difficult for me to comprehend
the thinking of our state and federal leadership, which both advocate
reduced income taxes with higher spending. Please explain.
S.W., California
02/02/04
Mr. Klotz responds: To answer your question
properly, we have to distinguish between the role of the state and
federal governments.
Deficit spending by the federal government has been an accepted
economic principal since John Maynard Keynes espoused his theories
in the 1930s. Contrary to the classical economists, Keynes believed
that governments should be actively involved in the economy to manage
the "level of demand."
He theorized that during recessions, the government should seek
to "reflate" the economy and conversely "deflate"
during boom times. One of the most significant methods of reinflating
the economy is through increasing the level of government expenditures
or reducing taxation to encourage spending by individuals and corporations.
Obviously, the downfall of this theory is the practical difficulty
in reducing government spending in times of prosperity.
States, on the other hand, because of their inability to print
money, are constrained to balance their budgets.
California finds itself in a budget predicament that was not planned.
It is a direct result of the unintended consequences of popular
legislation.
In California, enthusiasm for ballot initiatives has led to passage
of propositions, which have increased spending and dampened revenue
sources. Mandatory annual spending increases for purposes such as
education and transportation have increased the expenditure side
of the equation, while limits on property taxes (Proposition 13)
have led to increasing reliance on sales and income taxes, which
are more cyclical and therefore less reliable. The state Legislature
has little control over these types of revenues. Further, by reducing
property taxes, Proposition 13 necessitated a greater reliance on
state funding for local education.
As you can see, mandatory increases in spending along with increased
reliance on volatile revenue sources, combined with an economic
recession, is not a formula for balancing a budget.
To complicate matters, any new initiative designed to increase
taxes requires a two-thirds majority in the Legislature, which further
restricts policy-making options.
As dire as this situation appears, we expect that California voters
will bite the bullet; approve the deficit bond issue, and their
elected officials will implement spending reductions to restore
fiscal balance.
More Bond Forum:
Previous 1 2 3 4 5 6 7 8 Next
| 
