A Risk for Retirees: Is Your Bond Interest Really Principal in Disguise?



By Craig Rawlins, CFA, CFP®, CPA

Today’s market environment makes it more likely that you are unwittingly spending
your bond portfolio’s principal disguised as interest. Spending your portfolio’s
principal may make it more difficult to maintain your retirement income in the
future unless, of course, you plan for it.

To explain, let’s first review six terms that describe common characteristics of Bonds:

Principal is your purchase price which may be more or less than,
Par is the stated value if you hold the bond to maturity,
Premium is an amount paid above Par at purchase,
Discount is an amount paid below Par at purchase,
Yield is the stated interest rate of the bond at Par,
Interest is the Yield multiplied by the Bond’s Par Value.

Today’s market environment is characterized by relatively low interest rates. Many
bonds available for investment today and held in investor portfolios directly or in
bond funds were issued when rates were higher than current levels. These bonds
generally have a stated yield and pay interest above current market rates and are
valued at a premium to their par value.

If held to maturity, purchasers of these bonds will effectively suffer a loss in
principal equal to the premium paid. The good news is that this loss will be largely
offset by higher than market interest paid to the investor over the holding period.
The result is the investor receives an approximate market rate of interest when all is
said and done—there is no “free lunch”—and the higher than market interest was
effectively a return of principal (representing premium at purchase) in disguise.
The real risk is that investors will spend the higher interest income only to be
surprised when their principal falls in value. If interest rates stay at current levels
or decline further it may be challenging to maintain interest income levels without
taking on other portfolio risks.

Things you can do:

1. Review individual bonds in your portfolio to determine if you’ve purchased
them at a premium to par. If so, determine effects and plan accordingly.

2. Review bond funds in your portfolio to determine if the “Distribution Yield”
and/or “Average Coupon” is higher than the “Yield-to-Maturity”. If so,
determine effects and plan accordingly.

3. Discuss, review and plan accordingly with your Financial Advisor.

Craig A. Rawlins, CFA, CFP®, CPA, Investment Advisor Representative and Chief Investment Officer for Practical Portfolios LLC.
Discuss this article, A Risk for Retirees: Is Your Bond Interest Really Principal in Disguise?
Contact Craig at: phone: 920-333-2997 or email: crawlins@practicalportfolios.com
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