Many years ago, one of my clients inherited a large sum of callable out of state muni bonds (munis) in an account at a large, brand-name brokerage firm. As a resident of California, this client received none of the income tax benefits for the munis and wanted to know what to do.
After analyzing the clients situation, I determined that a diversified bond portfolio designed specifically for conservative investors and those funding near-term liabilities would be more appropriate. The portfolio has the following three characteristics:
- It is engineered around two empirically-validated fixed income (bond) factors: a). short to intermediate maturity of 1-5 years, and b). investment grade or high quality ratings.
- It is built using low cost mutual funds that invest in investment-grade bonds from around the world, including government, corporate and inflation protected securities.
- It has a close to zero correlation with U.S. or global stock markets.
The client liked the increased diversification, but balked when comparing the annual estimated income and current yield shown on the account statement against the recommended portfolio. The statement showed something very different than my analysis. The statement reported higher income than the taxable alternative. I could not believe my eyes!
If you saw what my client saw, you, too, would have said, “I’ll stick with what I have already.”
How could this be? Was this some kind of trick? My gut said something was wrong, but I couldn’t put my finger on it. So, I got curious and had to figure it out.
I spoke with a retired planner who worked at a large brand-named competitor back in the 70s and 80s about this. He explained that the bonds were purchased at a premium and will be called at par (par value). So, the way these firms calculate the numbers on their statements will show attractive, but overstated income.
I had learned a lot about how to decipher misleading accounts statements, but no one ever showed me this trick. That was my aha moment about the grand illusion of bond reporting.
Let me show you an example of how this works from my client’s statement. (Please note I rounded to the nearest $100 to keep the math easy to follow).
The broker (aka “financial advisor” at the large brokerage firm) buys a $10,000 callable AA rated muni that has a 5% coupon and is callable in five (5) years. The muni costs $10,800, or $800 over par value.
The firm’s account statement shows an annual income of $500 for the bond ($10,000 x 5%) and a yield of 4.63% ($500/$10,800). Since the muni is callable in five (5) years, the $500 of income will likely last only for that five-year period.
Remember that the bond was purchased at a premium ($800) and will be called at par ($10,000). When the muni is called, the investor will get back $800 less than the purchase price.
Here comes the first sleight of hand. So, watch carefully.
The $500 of annual income or coupon payment actually consists of two parts.
- Part 1 is a return of principal, which is approximately $160 ($800 divided by five years).
- Part 2 is actual income, which is the remaining $340 ($500 minus $160). While technically incorrect, one could conclude that the investor earned 3.4% ($340 / $10,000).
And here comes the next sleight of hand. The investor’s realized income will be less than $340 after commissions and fees – the broker doesn’t work for free. (And, in my client’s case, the net income would be even lower after paying income taxes).
By the way, my client’s brokerage statement had over three (3) pages of fine print and notes. I can usually go to the last few pages to read all the details and understand what’s really going on.
But, this time they got me.
After going through more statements, I finally found a note that bonds purchased at a premium show amortization of premium. However, instead of it being buried in the footer section of the bonds or at the end of the statement with all the other fine print, it was buried in notes interspersed throughout the statement.
My professional observations suggest few investors understand the convoluted statements they receive from these big, brand-named firms.
So, if I was fooled by this illusion, what are the chances that average investors understand this commonly practiced means of reporting?
And, the next time a bond in your portfolio looks like it’s generating higher than average income, check the bond ratings and then check the reporting.