It Doesn’t Add Up
Low interest rates are wreaking all sorts of havoc on savers, and in a case of kicking a saver while he is down, they are even facilitating the overstatement of the reported yield of some municipal bonds. In instances where bonds trade at a premium to face value, rules allow brokers to ignore the fact that the amount the investor pays for a bond is less than the amount that will be returned in principal upon maturity.
The Barclays Municipal Bond Index, a measure of the market for these tax-free bonds issued by state and local authorities, yields 2.2%. Even the Vanguard Long-Term Tax-Exempt Fund, which specializes in municipal debt maturing many years in the future, yields only 2.3%.
So how can so many brokers and financial advisers be such astute bond-pickers that they can claim to be earning yields of 4% and up without jeopardizing your capital? They can’t. Those yields are an illusion. You would never know it from looking at your account statement, however. Brokers and financial advisers are able to report the yield on many municipal bonds without adjusting for an inevitable decline in their price — thus significantly overstating the income you will earn.
To understand why, note that in a world of low interest rates, bonds are often issued at a “premium over par,” or initial price greater than $100 per $100 of par or principal value. But they almost always mature — or are “called,” if the issuer buys them back before maturity — at $100. Imagine this streamlined example: You pay $110 for a bond that pays 4% interest and matures four years from now. Each year, you will earn $4 in interest on each $100 you have invested in the bond. And when it matures, you will get $100 back — not $110.
So you will earn $16 in simple interest but lose $10 on your principal at maturity, a total gain of $6. Your adjusted return is nowhere near 4% per year; it’s approximately 1.5% ($6 divided by four). Under federal accounting and tax rules, a mutual fund or exchange-traded fund would be required to report the yield on that bond as approximately 1.5%. A broker or financial adviser, operating under rules from an industry self-regulator called the Municipal Securities Rulemaking Board, can report it at 3.6% ($4 in income divided by $110). Your brokerage or advisory account statement excludes future losses (or gains) on the bond’s principal when it reports yield. It’s simply an incomplete picture of your money.