There's only one investment recommendation that can make advisor Marilyn Bergen illustrate it to clients "with my arms out in the air like a teeter-totter," as she puts it.
That's premium bonds, says Bergen, a partner at Confluence Wealth Management in Portland, Ore. "For accounts that are large enough for adequate diversification, we have been using individual bonds for about three years," she says. "We've been laddering over a one- to five-year term because we are so concerned about what will happen to bond mutual funds when we get to a rising rate environment."
Bergen's acrobatics demonstrate the classic bond market basics: Higher interest rates mean lower bond prices, and vice versa. That vice versa is now very much a concern for financial planners.
Bond yields are very low: Popular funds from such families as Pimco and Vanguard now yield less than 4% or even less than 3%, according to Morningstar. If rates rise from today's nadir - or, more realistically, when they rise - bond funds are likely to lose value.
High-quality individual bonds, on the other hand, virtually guarantee a return of principal at maturity and the opportunity to reinvest the proceeds in the future at yields that might be higher. The catch: Rock-bottom yields have driven up the trading price of older bonds with high coupon rates.
"Almost all of the bonds have been purchased on the secondary market and therefore have been bought at a premium in recent years," says Bergen, whose firm typically uses a bond manager to select the individual issues.
A client who wants to buy, say, $100,000 in face value of municipal bonds maturing in seven years might have to pay a premium of around $120,000 to get those bonds. The prospect of a certain $20,000 decline in value may outweigh the risk of a bond fund loss from rising interest rates.
Bergen's gestures also indicate another issue for planners - how to explain the strategy clearly to clients. To communicate the plan, her firm initiates a "Bonds 101" discussion.
"We use an institutional bond manager to put together and monitor a municipal bond ladder," she says. A traditional bond ladder, of course, holds bonds with staggered maturities, providing for periodic reinvestment of redemption amounts. If interest rates rise in the future and bond fund prices fall, individual bondholders may reap ascending returns.
"Before we utilize this strategy," Bergen continues, "I'll have an education session, focusing on how credit quality and length to maturity have a big impact on the price of bonds, providing examples of both topics. Then I'll talk about the inverse relationship between bond prices and interest rates."
That's when the arm seesaw comes in - usually followed by Bergen's diagraming the trade-off on a piece of paper. "The idea is to explain why a purchaser needs to look at yield to maturity and the total return on the bond from purchase date to maturity," she explains.
Erika Safran, head of a wealth advisory firm in New York, says "a quick run of the numbers" can offer clarity when discussing premium bonds with clients.
As an example, she puts two bonds with almost the same yield to maturity side by side: a Torchmark bond with a 3.8% coupon and a Georgia-Pacific bond with an 8% coupon, both maturing in 10 years. The Torchmark issue is priced at almost $105 per $100 bond, with a 3.2% yield to maturity, while the Georgia-Pacific issue is priced at more than $140 per $100 bond, with a yield to maturity of 3.3%.
"Assuming a $100,000 face value," Safran says, "the Torchmark bond will pay about $38,000 in interest income over the next 10 years, while the Georgia-Pacific investors will get $80,000 over those 10 years." Accounting for the built-in loss of principal, the net cash flow over 10 years would be around $39,600 from the Georgia-Pacific bond and about $33,200 from the Torchmark issue.
"In addition," Safran says, "investors can take a tax loss on the premium paid." In this example, the Georgia-Pacific bond will provide a capital loss of around $40,000 at maturity.
Assuming this loss offsets long-term capital gains taxable at 20%, the tax savings would be around $8,000. The Torchmark bond, with a premium under 5%, would generate less tax savings 10 years in the future. "The investors also could amortize the premium annually," Safran says.
Indeed, the taxation of premium bonds is complicated and may prove to be another obstacle for advisors recommending them to clients.
An investor who buys a municipal bond at a premium must amortize that premium, reducing the basis over the bond's remaining life. For example, an investor who pays a $21,000 premium for a bond maturing in seven years would reduce the basis by around $3,000 a year. If that brings the basis down to par at redemption, there would be no federal tax benefit from this annual basis reduction, which represents declining bond value.
Premium taxable bonds, however, offer tax benefits as well as a choice of tax treatments. Investors can either forgo amortization or amortize the bond premium each year.
Amortizing a taxable bond premium each year may be a better choice, according to Bill Fleming, a Hartford, Conn., managing director and partner in PricewaterhouseCoopers' private company services practice. That's because the deduction can permit an investor to avoid paying ordinary income tax - now up to 39.6% - on interest income, and investors get the tax break sooner.
"To get the deduction," Fleming says, "investors need to know the premium amount and maturity date - data that's not usually part of tax-reporting packages."
In recent years, Fleming adds, some (but not all) brokers have become more helpful in providing the information needed to amortize taxable bond premiums. If investors choose to amortize bond premiums, that choice will apply to all of their taxable bonds, now and in the future, unless they receive IRS permission to make a change. (Use Form 3115 to request approval.)
Despite the need to educate clients, some advisors are receptive to buying individual bonds - premium bonds, in today's environment.
"I use individual bonds for clients in an opportunistic fashion," Safran says, "when I see a value with respect to credit, rates and/or maturity. I would consider buying premium bonds to satisfy income needs or for diversification. The interest income can be applied to dollar-cost-averaging strategies into other investments."
Premium bonds, she notes, are less sensitive to interest rate changes than discount bonds and thus less volatile.
Other planners say they have backed off from individual bonds. "We haven't bought any individual bonds for a while," says Bill Baldwin, president of Pillar Financial Advisors in Waltham, Mass. He cites yields that are well below historic averages: "Instead of individual bonds, many of our clients invest through bond funds, which tend to be intermediate-maturity funds." Such funds may deliver meaningful yields without enormous interest rate risk.
That said, certain clients still hold individual bonds rather than funds. "At a $1 million bond allocation," Baldwin says, "we generally start showing clients the separate account managers we work with. Their fees [of 25 to 35 basis points] are quite reasonable relative to funds." These managers differ in their strategies for fixed income.
"The bond manager we have used with the most success has adopted a barbell approach" - in which investors hold a mix of long- and short-term issues - "as a tactical measure, in anticipation of rising rates," Baldwin explains. "In this way, as interest rates rise, there will be short-term issues to sell off for reinvestment in longer-term issues.
"The logic is that, as rates rise, you extend maturities," he says. "If they rise more, you extend more to the extent your investment policy will allow. In that way, you are as long as possible when rates crest."
Another bond manager uses callable premium bonds, which pay fairly substantial yields, according to Baldwin. "This gives him very short duration," Baldwin says, "so it is very defensive. We also use a third manager, who employs a strict laddering approach."
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.
An earlier version of this article contained errors. Comparing a bond from Torchmark with one from Georgia-Pacific, the yield to maturity of the Georgia-Pacific bond should have been 3.3%, not 3.1%, as stated. In addition, the article should have said, Assuming $100,000 face value, not Assuming a $100,000 investment.