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Clipping Coupons

Adam M. Grossman

IN A TYPICAL YEAR, the bond market doesn’t attract much interest. That’s by design. The role of bonds in a portfolio is to serve as a bulwark against the unpredictability of stocks. They’re supposed to be boring.

All that changed this year. Thanks to rising interest rates, the most common total bond market index, the Bloomberg Aggregate, has lost about 11%. To put that in perspective, this index has delivered a negative return in only three of the past 25 years. Most years, it delivers a modest but respectable positive return. Since 1997, that has averaged about 5%.

At the same time, another type of bond has surged in value and gained in popularity. The U.S. Treasury’s Series I savings bonds—often referred to as I bonds—are tied to the Consumer Price Index and appreciate when inflation rises. As a result, earlier this year, I bonds were offering an interest rate of 9.62%. Even today, with inflation having moderated a bit, the Treasury is offering I bonds with an initial rate of 6.89%.

Result: Some investors this year have developed a newfound love for bonds, while others have been left disappointed. For that reason, it may be helpful to review five bond market nuances.

1. Yields on conventional bonds. You’ve probably heard the term “bond yield.” In simple terms, this refers to the income a bond produces. But as I’ve noted, yield can be calculated in several different ways.

If you’re considering an individual bond, you’ll generally see only its coupon rate and will need to calculate other yield figures manually. By contrast, if you’re looking at a bond fund, the manager will usually provide more yield information—but that doesn’t necessarily make things easier. Consult the iShares website, for example, to learn about its total bond market fund, and you’ll find four different yield numbers, ranging from 2.2% to 4.4%.

Which number should investors pay attention to? Fortunately, there’s an easy answer: Investors should focus on yield to maturity. This is the total return that an investor will earn if he buys a bond today and holds it to maturity.

Yield to maturity has two components: interest payments (often called coupons) and, potentially, a gain or loss on the price of the bond. Why might a bond gain or lose money while you own it? It’s because bonds can be purchased at discounts or at premiums to their face value. But regardless of the purchase price, investors will receive the bond’s face value at maturity.

Take the example of a bond maturing one year from today with a face value of $1,000 and a coupon rate of 3%. Suppose you purchase this bond at a discount. Instead of $1,000, you pay $990. Over the course of the next year, you’ll collect 3% in interest, plus—at maturity—you’ll pick up another $10 (the difference between $990 and $1,000). This $10 translates to 1% of the value of the bond, so in total you’ll earn 4%. That 4% is the yield to maturity on this bond. Because it represents an investor’s total investment gain, I believe it’s the most important number.

When it comes to bond funds, there isn’t a single yield to maturity that can be calculated. Still, fund companies publish a figure that’s a reasonable approximation.  This isn’t a perfect figure because the holdings in a fund can, and likely will, change. It’s for that reason that some bond investors prefer individual bonds, where the yield to maturity is mathematically guaranteed—assuming the issuer doesn’t default.

2. Yields on inflation-linked bonds. What about the yields on I bonds and their cousin, Treasury Inflation Protected Securities, otherwise known as TIPS? With these bonds, another yield figure is most important: the real yield. In economics, the term “real” refers to a number that’s been adjusted for inflation. For example, if a company raises the price of a product by 7%, but inflation is 5%, the real increase would be 2%.

What does this mean in the context of inflation-linked bonds? Both I bonds and TIPS have a real yield, which is the actual yield to maturity that they guarantee over and above inflation. Look at the Treasury’s I bond website today, and you’ll see this described as the “fixed rate.” Currently, it’s 0.4%. The remainder of the 6.89% rate advertised is attributable to the inflation adjustment. This distinction is important to understand because the Treasury adjusts the latter component in response to inflation every six months. In other words, that 6.89% is not guaranteed for the life of the bond. Investors are only guaranteed 0.4% above inflation. If inflation moderates, so too will the nominal return on I bonds.

Real yield is also a useful metric for comparing I bonds and TIPS. All last year, and through the first half of this year, TIPS were quite expensive and, as a result, offered a negative real yield. But that’s changed, and today real yields on TIPS are positive. The rate Friday was 1.45% on five-year Treasury notes. Thus, in comparison to I bonds—which are offering a real yield of just 0.4%—TIPS today represent a much better deal. Yields change all the time, though, so if you’re considering inflation-linked bonds, start by comparing their real yields. TIPS and I bonds have a few other differences, but I see this as the most fundamental consideration.

3. “Phantom income” from inflation-linked bonds. Both TIPS and I bonds carry another unique characteristic: Over time, as their value adjusts in response to the latest inflation reading, they will generate what’s commonly referred to as phantom income. This is reported to you—and to the IRS—as income, but as a bondholder, you won’t actually receive a cash payment. For that reason, you’ll want to try to sidestep this phantom income.

For TIPS, the solution is to hold the bonds only in a tax-deferred account, such as an IRA or a 401(k). I bonds, on the other hand, can’t be held in a retirement account. But the Treasury offers another way to sidestep this unfavorable tax treatment. If you purchase an I bond, choose the “cash basis accounting” option. That way, the income will be reported only when you redeem your bond, better aligning the tax bill with when you get your I bond proceeds.

4. Coupon choices. As I mentioned above, a bond’s coupon rate is just one component of its yield to maturity. The other is the bond’s price. Indeed, two bonds can carry identical yields to maturity but have very different coupon rates. Short-term bonds today, for example, carry yields to maturity around 4.5%. But among bonds with that same yield, some will have coupon rates above 4.5% and some below. In fact, some bonds pay no interest at all—that is, they have 0% coupons.

If yield to maturity is most important, should you be totally indifferent to a bond’s coupon rate? Mathematically, if a bond is held to maturity, an investor would indeed be indifferent. But especially if you’re purchasing a bond with a maturity of more than a few years, you do want to pay attention to the coupon rate. Your choice here will depend on your objectives.

Some investors prefer higher coupon payments so they can use that reliable income to meet household expenses. Others prefer the opposite. Investors who don’t need the coupon income often find it simpler to buy bonds with lower, or even zero, coupon rates. That saves them the trouble of reinvesting income payments along the way. This can be especially valuable if you’re worried that interest rates might drop in the future. When that happens, investors face what’s called “reinvestment risk.” If rates on newer bonds are lower, it will be hard to maintain the overall yield to maturity of a bond portfolio. It’s for that reason that zero-coupon bonds—which sound counterintuitive—are quite popular. They eliminate reinvestment risk.

5. A bond market misnomer. A final point for bond investors: While total bond market index funds are popular, their name is misleading. The Bloomberg Aggregate index, on which these funds are based, doesn’t include inflation-linked bonds. Want inflation protection? Be sure to make a separate purchase of either I bonds or TIPS.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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