Investing Strategy: Individual Premium Bonds
by: Donald Jay Korn
Saturday, June 1, 2013
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.
BASIC TRAINING
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.)
OPPORTUNISTIC USE
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.
LONG-SHORT MIX
"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.”