The search for yield in this zero-interest-rate environment is causing many retired persons to fall into a bond trap that will be a complete surprise. And it will cost a lot of money.
Most investors assume the “coupon” rate is what they earn while owning the bond. Depending on the price of a bond, your return and your interest rate can be two very different numbers.
And it’s the annual return that matters.
Bonds are issued in $1,000 increments. If you pay $1,000, or par, for the bond, your annual return is the same as the coupon.
If you are lucky and find a bond in this market that is selling for less than par (less than $1,000), your annual return can be higher than the coupon.
That’s a very good thing.
But, in this market, discounted bonds are very rare. Just about any bond worth owning is selling at a premium… and this is where a lot of retired folks will have their heads handed to them.
Many are buying and being sold premium bonds that appear to pay high returns, but in reality have very low returns.
Take a look at this bond:
Monsanto (CUSIP 61166WAF8) — Rated A+, Coupon 5.125%, Cost 119.8
To the unfamiliar, an A+ bond with a 5.125% coupon looks like a huge return, especially in this market. But here’s where the trouble starts.
The price of the bond is 119.8, which equates to $1,198 per bond. You only get $1,000 at maturity, so you have a $198 loss on every bond.
By the time you subtract the $198 loss, your real annual return drops from the 5.15% coupon to an annual return of just 1.043%.
You are paid interest annually of $51.25 for every bond, which equates to 5.125%. But the premium you paid drags your return down to savings account and CD rates.
There is nothing wrong with paying a premium. It is a fact of life in this market. But you have to make sure you know how much you are really making after the premium is paid.
Here’s a bond that sells at a premium but is paying enough to make it worth doing:
Kemet (CUSIP 488360AF5) — Rated B+, Coupon 10.5%, Cost 104.95
This bond, after you pay the $49.50 premium, will return 8.619% annually. And that’s a yield worth owning.
Make sure you know what your bonds are really paying.
Editor’s Note: Someday very soon, interest rates are going to become extremely volatile. When they do, there is one investment that will soar above the rest. To read about it… click here.