Muni Bonds Yielding 4%?
November 12, 2015

Have you heard about the municipal bonds that you can buy with a 4% yield?

Unless it is a “junk” quality bond, you are probably not getting a 4% return on your investment.  It’s all in the way that it is presented.

In a low interest rate environment, bonds are often issued at a price over the par value of $100 (or at a premium), but mature, or are called, at par.  For example, if you buy a bond at $110 with a 4% coupon that matures in 4 years, you will earn $4 per year and $100 when the bond matures.  So, you will earn $16 in income and lose $10 on the principal when the bond matures for a net gain of $6.  So that bond with a 4% yield is really only returning 1.5% ($6/4years) to you the holder.

Mutual funds and ETF’s (exchange traded funds) report a truer yield on their bond funds as rules require a calculation that accounts for the decline in principal and would report the yield of 1.5% ($6/4 years).

Governed under different rules, a broker can calculate the yield by dividing the $4 income by the $110 purchase price for a yield of 3.6%.  Included in this yield is the premium you paid for the bond that you did not get back when the bond matured.

Most brokerage firms do include a footnote explaining that the calculation method used may overstate the yield, but the practice can be viewed as confusing or even misleading.

Mutual Funds and brokerage firms are playing the same game, but using different rules.  Mutual funds and ETFs operate under federal accounting and tax rules while brokers operate under the rules of a self-regulatory organization called the Municipal Securities Rulemaking Board (MSRB).

Jason Zweig addresses this issue in a recent Wall Street Journal article; (http://www.wsj.com/articles/howmunibondsyield4ina2world1446260554

Please call us if you have any questions.

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Susan Templeton

November 2015