Charles Ray, Puzzle Bottle. 1995. Glass, painted wood.
Despite the recent increases in interest rates, many investors are still reaching for income in the current low interest rate environment. When interest rates are low, it is common for the coupon payments an investor receives to overstate their actual bond return. For example, when you see that your portfolio includes a 10-year bond with a 5% coupon, while the 10-year Treasury yield is 2.4%, is it time to congratulate your advisor on her brilliance in finding income for you?
Before we answer that question, let’s take a closer look at your brokerage account statement. If you see that the cost of this bond is over 100, then your advisor bought what is called a “premium bond”. A premium bond is a bond for which you paid more than its face value. For example, if your statement indicates a cost of 110.5, then you paid $1,105 for a bond for which you will receive $1,000 at maturity. That means that your “current yield” (defined as the 5% coupon payment divided by the price paid for the bond) is 4.5%, not 5%. The higher the premium paid for the bond and the closer the maturity date, the lower the actual yield earned on it and the more misleading it is to look at the coupon alone.
Now let’s look at the estimated income figure on your statement. It is typically in the far right column of the fixed income section of your statement. The estimated income figure is simply the coupon payment, which in this example, would be $50 per bond. If you use all this income for living expenses, you are depleting your principal. That is because part of that income is the return of the premium you already paid and that you will not get back at maturity.
Should you avoid premium bonds? No. But you should be aware that the return on this investment is lower than it appears. The interest income you are receiving is really both the return you are earning and a return of the premium you paid. To be certain you are not pulling too much out of your bond portfolio, withdraw only the portion equal to your yield to maturity when you bought the bond.[1]
[1] The yield calculation is more complicated for callable bonds.
DISCLAIMER: This information is not intended to provide legal or accounting advice, or to address specific situations. Please consult with your legal or tax advisor to supplement and verify what you learn here. This is presented for informational or educational purposes only and does not constitute a recommendation to buy/sell any security investment or other product, nor is this an offer or a solicitation of an offer to buy/sell any security investment or other product. Any opinion or estimate constitutes that of the writer only, and is subject to change without notice. The above may contain information obtained from sources believed to be reliable. No guarantees are made about the accuracy or completeness of information provided. Past performance is no guarantee of future results.