Our Ten Year Rule philosophy calls for investors to have 10 years of liquidity in fixed-income investments with maturities occurring in the years of the liquidity need. However, with the extremely low interest rates currently available, investors are finding it difficult to find any quality fixed investments. We recently spoke with a client who had a friend who claimed to have a bond paying 7% interest.
Even the lowest investment-grade 10-year corporate bonds are not paying 7%! As is often the case, in social settings, people brag about what they are making, but neglect to mention how much they are losing. You can buy a $1,000 bond with a coupon of 7% that will pay $70 a year, but you will pay a hefty premium unless the credit quality is absolutely awful.
In general, the return of a bond is largely determined by its interest rate. A bond’s interest rate generally depends on current interest rates available in the market and the creditworthiness of the issuer, which is determined by rating agencies, such as, Standard & Poor’s and Moody’s. A coupon rate is generally paid semiannually and so named because bonds literally had coupons attached to them. The holders received interest by stripping the coupons and redeeming them. Nowadays, coupons are tracked and redeemed electronically. When it comes to premiums and discounts, investors are looking at the purchase price that is above or below the par value.
In our example, we are likely looking at a 10-year bond with a par value of $1,000 that is selling for a premium, perhaps around $1,300 if it pays $70 a year. If you should need to sell the bond before the maturity date, you have a much higher risk for losing your principle.
When we look for bonds, we recommend bonds rated AA or better, ensuring we buy top-tier quality bonds. Even at a 10-year maturity, top rated bonds are yielding very little. In short maturity bonds, you are likely looking at 0.2% interest on a six-month; 0.35% on a one-year bond, or 1.30% on an 18-month CD.
The municipal bond market also appears to have already priced in an increase in taxes next year. As taxes climb higher, the tax equivalent yield increases; thus, you will get more benefit from the non-taxable bond, which in turn is driving the yields down further.
For our clients, we are buying bonds within a five-year range. There is certainly nothing available paying 7% that remotely meets our investment criteria. We spend a significant amount of time searching for high-quality fixed investments. We often buy short-term CDs and when those mature, we look again at the bond market. As market yields increase, the yield on a bond will increase; however, then the bond prices will go down. At the moment, there is a risk of losing principle.
We buy bonds based on their yield to maturity with expectations of holding them to maturity, thereby locking in that yield. If you buy a 10-year bond when market yields are relatively low, and you decide to sell it in three years, you stand to lose principle. There is risk involved in buying bonds.
If something appears too good to be true, it generally is. In finance, if you are getting excessive yield, you are probably taking on excessive risk.