Net negative bond investment?

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Topic Author
SalishSea
Posts: 2
Joined: Tue Apr 13, 2021 9:44 pm

Net negative bond investment?

Post by SalishSea »

First ever post
A financial advisor recently purchased an individual corporate bond on the secondary market and I'm trying to figure out if it was a bad investment. I want to make sure I am understanding the math correctly before I bring up my concerns with them. Approximate details are below, please let me know if my math is off or if I'm misunderstanding bonds.

Face Value: 35,000
Price paid: 38,400
Yield: 3.7%
Duration: 3 years
Federal Tax Bracket: Likely 22% (it is held in a taxable account)

Based on running the numbers, it doesn't seem like a great deal:
Interest (total): 35,000 * 3.7% * 3 years = 3,885 (1,295 / year)
Return of face value at year 3: 35,000
Total Return (pre-tax): 38,885
Return minus price paid: 38,885 - 38,400 = 485 (pre-tax)

Return minus price paid and taxes:
Taxes (total): 3,885 * 22% * 3 years = 855 (285 / year)
38,885 - 38,400 - 855 = -370 (after tax)

Based on my math it seems like I'll have a negative after tax bond return of $370 over 3 years, while also taking some (albeit low) credit risk.
If this is the case, I want to discuss future bond purchases with them. My sense is that an investment grade corporate bond fund/ETF could have a higher yield and potentially even less credit risk.

Thanks so much!
fabdog
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Location: Williamsburg VA

Re: Net negative bond investment?

Post by fabdog »

Welcome to the world of bond amortization.... Your advisor is likely touting the 3.7% return you're getting on the bond they purchased... but to get a 3.7% return now, you have to pay over face value... which gets you the current market rate on a YTM basis

at the end of the year your 1099 will show the interest you got, ans well as the amortization of the premium you paid for the bond... and no your math is not off.. holding the bond to maturity will net you $485 before tax....

the good(?) news is that the interest you report will be the coupon payments, less the amortization for that year... so you're not getting taxed on the full interest... just your net after the amortization

There may be some accrued interest that comes your way depending on when the bond was purchased... but yeah, this is a terrible deal... but it's whats available in the market

Ask your advisor to explain what interest rate you are getting.. when he/she says 3.7% ask them what NET rate... if necessary ask them how much of this is getting eaten up by the amortization of premium that was paid for the bond

Mike
Last edited by fabdog on Sun May 02, 2021 7:25 pm, edited 1 time in total.
livesoft
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Re: Net negative bond investment?

Post by livesoft »

There are commissions to buy bonds and then there is the cut that the advisor takes, too.
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retired@50
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Re: Net negative bond investment?

Post by retired@50 »

SalishSea wrote: Sun May 02, 2021 3:32 pm ...
Price paid: 38,400
...
Thanks so much!
Welcome to the forum. :happy
Sorry it's under these circumstances.

Ally is currently offering a 3-year "High Yield CD" at .65% interest.
https://www.ally.com/bank/high-yield-cd/
Scroll down to use the calculation tool on the website.

$38,400 X .0065 = $249.60 interest in year 1. Assume interest is re-invested at the same rate.
$38,649.60 X .0065 = $251.22 interest in year 2. Assume interest is re-invested at the same rate.
$38,900.82 X .0065 = $252.86 interest in year 3.
For a total of $753.68 in taxable interest.

The bond appears to be worse than a CD, with far more risk. Time to get away from this adviser.

Regards,
This is one person's opinion. Nothing more.
hi_there
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Joined: Sat Aug 29, 2020 7:00 pm

Re: Net negative bond investment?

Post by hi_there »

As their client, you have the right to raise these valid concerns and ask about the this purchase decision, and I would encourage you to do exactly that.
Topic Author
SalishSea
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Joined: Tue Apr 13, 2021 9:44 pm

Re: Net negative bond investment?

Post by SalishSea »

Thank you all for the great information! I've been reading this forum for several months now and it's exciting to post and get the great feedback.

This all confirms my thinking that the bond is a very bad deal. The information will be helpful to feel more confident when I ask the advisor why this individual bond is favorable to a high-yield savings account, or something like Vanguard's short-term bond ETF (BSV) which has a superior YTM (0.6%), with essentially the same average effective maturity, and I'm assuming far more liquidity than an individual bond holding. Or simply a Vanguard total or intermediate bond ETF.

Thanks!
Karamatsu
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Re: Net negative bond investment?

Post by Karamatsu »

Just a couple of things. First, if you paid 38,400 for the bond and it's yielding 3.7% then the coupon rate must be more like 4% and your annual interest payments will be about $1,420 rather than $1,295 (there's round-off error so it's hard to be exact). Second, any bond yielding 3.7% in the current environment will be rated below investment grade, BB or BB- equivalent, so you should make sure you're OK with the issuer risk. Probably your advisor thinks the bond is an under-rated gem and that with only three years to go, it's solid. But of course, it's not his money.

Otherwise, yeah... it's a hard time for bonds. For comparison, the yield on Vanguard's intermediate corporate bond ETF (VCIT) is 2.69% for investment-grade bonds, so a full point lower. On the other hand, if I understand US tax law correctly, dividends from a bond fund are taxed at the lower dividend rate, so the after-tax return will be closer, plus with the fund you get broad diversification and better quality. But I only bring it up so you'll have something to compare against.
not4me
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Re: Net negative bond investment?

Post by not4me »

SalishSea wrote: Sun May 02, 2021 10:56 pm Thank you all for the great information! I've been reading this forum for several months now and it's exciting to post and get the great feedback.

This all confirms my thinking that the bond is a very bad deal. The information will be helpful to feel more confident when I ask the advisor why this individual bond is favorable to a high-yield savings account, or something like Vanguard's short-term bond ETF (BSV) which has a superior YTM (0.6%), with essentially the same average effective maturity, and I'm assuming far more liquidity than an individual bond holding. Or simply a Vanguard total or intermediate bond ETF.

Thanks!
I don't think you've given enough data to say whether this is "very bad". I'll mainly summarize what has been said & add a tad (if nothing else in hopes of clarifying for later readers in similar cases).

1st, I'm certainly not saying there are any "good" fixed income investments now. But relative to other fixed income (such as those mentioned), it may be "typical". As pointed out, buying an individual bond will have some buying costs. Broker may have found a hidden gem, or unloading an undesirable bond from their inventory. These costs will likely be larger than ongoing expense of mutual fund, but to be fair they do offset some.

It isn't clear to me if the 3.7% is coupon rate, current yield or yield to maturity, or YTM, etc (I'm assuming no calls). OP, your math seemed to use a coupon rate of 3.7% -- which I think in this case gets you a ytm of .45% to .5%. To clarify though on the tax, only about $485 would be taxed. If the 3.7% is really "current" yield, then ytm is closer to .7% which seems most likely.

It can be tricky to compare an individual bond to multi year CD, savings account, etf, funds -- especially for a rather short period. Risks mentioned include the credit & liquidity risk, but there are also re-investment risk/considerations. Answer depends on whether rates will rise or fall & in what sequence. You also have more opportunity to sell before maturity & have a capital gain/loss.

It is good for you to have this conversation with the FA & hopefully it will clarify expectations, risk tolerance, as well as detail. If you want, you could post the cusip & I'm sure you'd get help understanding better about the details.

ETA: Does it have a duration of 3 years or mature in 3 years?
grok87
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Re: Net negative bond investment?

Post by grok87 »

I agree with this.
Karamatsu wrote: Mon May 03, 2021 2:05 am Just a couple of things. First, if you paid 38,400 for the bond and it's yielding 3.7% then the coupon rate must be more like 4% and your annual interest payments will be about $1,420 rather than $1,295 (there's round-off error so it's hard to be exact). Second, any bond yielding 3.7% in the current environment will be rated below investment grade, BB or BB- equivalent, so you should make sure you're OK with the issuer risk. Probably your advisor thinks the bond is an under-rated gem and that with only three years to go, it's solid. But of course, it's not his money.

Otherwise, yeah... it's a hard time for bonds. For comparison, the yield on Vanguard's intermediate corporate bond ETF (VCIT) is 2.69% for investment-grade bonds, so a full point lower.
But this part is not correct.
Karamatsu wrote: Mon May 03, 2021 2:05 am On the other hand, if I understand US tax law correctly, dividends from a bond fund are taxed at the lower dividend rate, so the after-tax return will be closer,
bond fund dividends are taxed at ordinary income tax rates just like bond interest. for stock funds some of the dividends may be deemed "qualified" dividends (there are a variety of conditions) in which case lower tax rates apply. sometimes bond funds issue long term capital gain distributions and those could be taxed at lower rates.

cheers,
grok
RIP Mr. Bogle.
Karamatsu
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Joined: Mon Oct 27, 2008 2:42 am

Re: Net negative bond investment?

Post by Karamatsu »

Thanks for clarifying the tax treatment. My 1099 always show dividends from bond funds, but little or no interest, so I just assumed that the dividends were interest payments being passed through. I guess they must be doing some sort of financial engineering under the hood.
grok87
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Joined: Tue Feb 27, 2007 9:00 pm

Re: Net negative bond investment?

Post by grok87 »

Karamatsu wrote: Mon May 03, 2021 8:21 pm Thanks for clarifying the tax treatment. My 1099 always show dividends from bond funds, but little or no interest, so I just assumed that the dividends were interest payments being passed through. I guess they must be doing some sort of financial engineering under the hood.
my pleasure

dividends from bond funds are just interest being passed through but may include some short term capital gains. all taxed the same way, as ordinary income. you would get interest from individual bond holdings not from bond funds.
RIP Mr. Bogle.
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