Allan S. Roth prefers low-cost diversified bond funds for investors seeking the best interest yields on their investments. Mr. Roth, the noted financial planner and Wall Street Journal contributor, periodically reviews clients’ portfolios and makes recommendations. Sometimes the only thing a client wants to keep is the municipal bond manager who seems to be producing over 4% tax-free. But Mr. Roth, who has closely examined the world of municipal bonds, has concluded that the apparent rates of return are not nearly as good as they appear to be. In fact, he believes that the entire bond market is an illusion, not just municipal bonds.
Mr. Roth’s article on the subject, “Beware the Muni-Bond Illusion,” uses a particular municipal bond to expose the illusion. The bond he picked out matures in 4 years and the coupon rate is 4.5% – not bad, he says. The client’s bond manager bought it a $112 – $12 over par, however, which reduces the interest rate down to 4.0% – still not bad at all, though, especially compared to the Vanguard Intermediate-Term Tax-Exempt Fund (Admiral Shares) return of 1.64%. Right? Wrong.
The actual return netted by the investor is very different. First, the $12 premium pulls the 4% yield down to 1.3%, because at maturity the bond pays $100, not the $112 that was invested, and the $12 that is lost in this way at the rate of $3.00 per year over 4 years equals 2.7%.
Peeling back another layer of illusion, Mr. Roth points out that the muni bond manager charges a management fee of 1% per year, which reduces the 1.3% annual return down to 0.3%. Now the stodgy 1.64% return of the Vanguard fund looks much better.
Mr. Roth’s article is reminiscent of an entertaining book written by a magician named The Amazing Randi. He followed a self-proclaimed supernatural showman named Uri Geller around like a one-man truth squad, exposing the slight of hand tricks Geller used to bamboozle audiences by supposedly bending spoons and things by his powers of concentration, and probably making Geller very angry. It is a book that could be applied appropriately to the world of investments.
In today’s low interest rate environment, it is frustrating for income-oriented investors to learn how various investment strategies may be flawed. But it is clearly better to find out this way than after the fact.
Page Perry is an Atlanta-based law firm with over 150 years of collective experience maintaining integrity in the investment markets and protecting investor rights.