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Have the low interest rates
available lately tempted you to reach for higher rates in
new places? Low interest rate environments always make it
difficult for those who rely on the income from their
investments to support their lifestyle. But before you start
searching for sources that provide a greater return, it is
vital that you understand that it’s not the yield that
matters.
I have a client who recently retired with well over a
million dollars. He needs to earn roughly 6% a year on his
investments to allow him to maintain his lifestyle without
using his principal. With rates on short-term Certificates
of Deposit paying only around 2% and the 10-year Treasury
Note only paying 4.25%, it is a challenge for him to get the
income he desires. In his frustration with these low rates
he has been tempted to reach for higher yields.
“Jeff, there’s got to be something better. What about these
bonds I see in the Wall Street Journal? There are some that
are yielding over 7%.”
These rates only tell a part of the story. When analyzing
income oriented-investments, the yield quoted in the
newspaper may be considerably different than the return you
actually receive.
Understanding the relationship of the quoted yield and the
price of the bond is the first step in calculating your
actual return. The yield often quoted in newspapers is
referred to as the coupon rate. If a bond has a coupon rate
of 7%, the issuing company will pay whoever owns each $1,000
bond $70 per year in interest. But your return is based on
how much you paid for that bond. For instance, right now you
would have to pay $1,400 for that bond, which means that
your yield would actually be 5%, not 7%. This is called your
yield to maturity.
But you must also consider the yield to call. Many bonds are
callable, which means they can be paid off early. Some can
be called as early as a few months after issue, others years
later. If you pay more than $1,000 per bond and it is taken
away from you early, your return can be substantially less
than the yield to maturity. For instance, if you buy a 7%
10-year corporate bond, callable at face value in 5 years,
it would cost you $1,200 per thousand dollar bond. This
would give you a yield to maturity of 4.5% but a yield to
call of only 2.7%.
The reason the yield to call is so much less than the yield
to maturity is because you ‘lose’ the premium you paid for
the bond over a shorter period of time. So, in this example,
you ‘lose’ the $200 extra per bond over 5 years instead of
over 10 years. That’s a reduction of $400 per year as
opposed to $200 per year. The yield to call takes these
factors into account.
Our example discussed the effect of paying more than $1,000
per bond. When paying a ‘premium’ the yield to call will
always be lower than the yield to maturity. If you pay less
than $1,000 per bond you still receive $1,000 when it comes
due. So instead of ‘losing’ that difference you are actually
earning it. So on ‘discount’ bonds, the yield to call will
always be higher than the yield to maturity.
Instead of looking at the coupon rate, it is better to look
at the yield to worst. Yield to worst is the lowest return
you would have in the event the bond either lasted until
maturity or was called early. The yield to worst only
includes the effects of paying more or less than the face
value of the bond and the call provisions. It does not
include other factors that could affect the overall value of
the bond or the issuers ability to repay it at maturity.
When my client found out that the yield to worst on those 7%
bonds in the newspaper was actually 4%, he realized they
weren’t as good of a deal as he thought. So when looking for
income-oriented investments, remember it’s not the yield
that matters.
For free, clear, unbiased answers to your financial
questions send me an email or give me a call.
Mr. Voudrie is a Certified Financial Planner, nationally
syndicated newspaper columnist, holder of 4 financial
related Patents-Pending, and President of Legacy Planning
Group, Inc., a Private Wealth Management Firm in Johnson
City, TN. He can be reached toll-free at 1-877-827-1463 or
at
jeff@guardingyourwealth.com.
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