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Author: trader2012 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35357  
Subject: Assured GTY’s 7’s of ’34, Agai Date: 9/19/2012 12:04 PM
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Of the currently-offered bonds rated A3/A- or better, Assured GTY’s 7’s of ’34 have the highest YTM. (6.27% on a purchase of five when executed through E*Trade). But is that, really, an acceptable yield? Your answer will depend on whether your intentions are to lose money or not. So let’s make the unwarranted assumption that the bond will mature and that default-risk isn’t a concern. Instead, our only concern will be the impact of taxes and inflation.

Let’s make the unwarranted assumption that forward tax-rates will be the same as present ones, namely, 15% on capital gains and 25% on ordinary income. Therefore, the income-stream from coupons will have to be reduced, but the loss from buying at a premium to par will create an eventual tax-credit.

Let’s also make the very much warranted assumption that the BLS numbers under-report inflation as most households experience it, and let’s make the probably justified assumption that Bernanke’s endless printing of money will have an inflationary effect, which has been the long-stated intention of his policies. But let’s also make the maybe justified assumption that inflation will merely rise a bit, not go hyperbolic , and that 5% is a middle-of-the-field guess as to what the average inflation-rate will be over the holding-period of the bond.

If you dump those numbers and assumptions into Excel and run them out for each coupon payment date, it’s easy to how your implied return on the bond of 6.27% becomes something far less. Over the 21.7 year holding-period, you will lose, on average, approximately (-2.3%) of your initial purchasing-power PER YEAR! In other words, to buy that bond is to trade future purchasing-power for present-income. That is a trade than can be made. But it is one that should be entered into knowingly.

As a rough rule-of-thumb, in today’s market and tax-rates and inflation-rates, any bond offering less than 8% is going to lose you money, which isn’t to say that every bond that you purchase must offer 8% or better, only that if the average yield of your bond purchases isn’t 8% or better, you aren’t preserving your purchasing-power, which, again, might be your intention. Most retirees (and would-be retirees) intend to spend down their accumulated wealth, and they hope they “die broke”, leaving as little of an estate as possible. The problem with such a plan is that investment-gains are typically over-estimated, and life-spans and tax/inflation-rates are typically under-estimated. Or to put it in another words, to optimize is to fragilize. If one’s assumptions leave little room for error, it can be assumed that error will happen, and generally not in the direction one hopes.

So, what to do? Presently, bonds are expensive, and the fixed-income markets are a mess due central-banker interventions. If you do have to buy bonds (or bond-equivalents) as part of your over-all, long-term investment plan, then shop very, very carefully and take into consideration all of your risks, not the least of which will be inflation-risk and tax-risk.

Charlie
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