Money Matters: Resist the yield mindset -- instead think return

By Cody B. Bartlett Jr. The Daily Record Newswire Before the modernization of financial markets, fixed income investors relied heavily on coupon payments to support their retirement. A bondholder would physically mail a coupon into the issuer and receive a cash payment. Since there was not much of a secondary market for bonds and the commission to sell a bond was quite large, the fix on bond yield made a lot of sense. In today's world, most investors hold bonds individually in a brokerage account or they will purchase a mutual fund that holds a diversified portfolio of bonds. Secondary markets for individual bonds are much more robust than they were in the days of the physical coupon and commissions are much more reasonable. Additionally, bond funds allow investors daily liquidity at market price, many times without having to pay any commission or sales loads. Now that bond investors can sell bonds inexpensively to service liquidity (expense) needs, yield should be of relatively little importance to investors even if they rely on the income to live. Investors, and their brokers, should be more focused upon after-tax total return as this is the bottom line when investing in fixed income securities. Sophisticated, value-oriented investors will thrive in low interest rate market environments by selling high coupon rate product at rich valuations and buying low coupon bonds on the cheap. Keep in mind, the market price of a bond reflects its coupon rate relative to the current market interest rate. For example, if a 10-year bond pays income (coupon) of 5 percent a year but the market rate for that maturity is only 2 percent, then the bond will trade at a premium (above $100). At the time of issue, 5 percent was the market interest rate however. Typically, when market rates are low for an extended period of time, as they are now and were back in 2004, retail investors get nervous and pay up for higher yielding bonds. This behavior is very dangerous and also unnecessary in today's more liquid bond market. By increasing their yield, bond investors usually do not realize that they are also increasing their interest rate and/or credit quality (default) risk. Unfortunately, the market offers no free lunches so an increase in yield will usually come with a corresponding increase in risk. It is often ignored that "income" could instead be generated by selling bonds. Selling bonds for "income" has two distinct advantages over swapping bonds for a higher yield: 1) commissions may be reduced, as when a swap is done a bond must be sold and another replacement bond purchased, whereas selling a bond involves one commission; 2) more importantly, the investor is able to maintain his/her current risk exposure. Increasing one's bond risk in a low interest rate environment can be very damaging as the next move in market interest rates will likely be up, which will lead to price depreciation. Additionally, rates are usually low due to an attempt by the Federal Reserve to stimulate the economy out of a recession or sluggish growth and bond defaults tend to increase during such periods of time. I would strongly advise bondholders to avoid the yield mentality and think in terms of total return. Of course certain legal and tax restrictions will modify this fairly simple advice. (For example, some trusts only allow the beneficiary to withdraw income generated by the bonds in the trust.) In general, think return and not yield and your retirement will be the beneficiary. Cody B. Bartlett Jr. is managing director of investments/investment strategist at Karpus Investment Management. He can be reached at (585) 586-4680. Published: Thu, Apr 7, 2011