President Perceptive Business Solutions Inc.
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What Accounting Professionals Should Know About Bonds

Many people need income now, yet don’t mind tying up the money if they can get a higher return. Here's what you can tell them.

Nov 4th 2019
President Perceptive Business Solutions Inc.
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Expanding to include financial advising services
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We are currently living in a low interest rate environment. Great if your business is borrowing money, not so great if your client needs interest to supplement their retirement income. As their accountant, your role as a fiduciary is a big advantage. How could you advise them?

The first consideration is “For how long?” If your client has extra cash and needs to pay their child’s spring college tuition, the money is best placed in a time deposit (CD) at their bank. They can’t afford to take any risks. The need will be real a few months away.

Many people need income now, yet don’t mind tying up the money if they can get a higher return. These people typically buy fixed income instruments, commonly called bonds. The issuer borrows the money for a specific period. They pay at the declared rate of interest. You get your money back at maturity.

There are plenty of people seeking to make money from your client. They also offer advice. In your role as a fiduciary, representing your client’s best interests, you can provide some education.

Investors who want income often buy bonds. The three primary types of bonds are:

  • US Treasury Bonds. Backed by the faith and credit to the US Government. They are generally considered the safest. They also pay less interest than others, however interest is free of state and local taxes.
  • Municipal Bonds.  These are issued by states, cities and their agencies. Bonds designated as General Obligation are backed by the taxing power of the issuer. That’s often considered the strongest guarantee.  Agency bonds are issued and backed by a specific operation within the state. It might be toll roads or the water authority. They are backed by the revenue from that specific source. If there’s a problem, the state isn’t obligated to step in.  Moral obligation bonds are for projects that fund good purposes, but don’t have as strong or specific a revenue stream. It’s assumed the state would stand behind them because it’s the right thing to do. That’s not a requirement. A major advantage is the interest earned is free of Federal income taxes. If the bonds come from your state, they are usually free of state and local income taxes too. Bonds issued by US territories like Puerto Rico are free of taxes on all three levels.                                         
  • Corporate Bonds. These are issued by businesses. They are an obligation of the business. There’s a pecking order. Some are secured by specific assets like an airline’s planes. Others, called debentures are further down the pecking order. Debtors are ahead of shareholders if a company gets into trouble.

Banks issue certificates of deposit. (CDs). They usually have the benefit of insurance. They are usually noncallable, yet can be redeemed early at a penalty. They are taxable on all three levels when held in a taxable account.

All bonds are not created equal.  Your client wats the issuer to pay off at maturity.  How do you quantify the risk?  Enter the rating agencies.  Several rating agencies assign scores. Standard & Poor's, Moody's and Fitch are three major names. They have three tiers in alphabetical categories: A, B, C and default. (D). Within each tier are three more tiers. For example, the “B” category has BBB, BB and B. To make this more confusing, there are three further categories: BBB bonds might be BBB+, BBB or BBB-. Simply put, AAA to BBB are considered investment grade. Anything below is in the junk bond category.

A bond is a promise to pay the holder the face value at maturity. That’s pretty straightforward, but there are other considerations. Bonds often have call features, allowing the issuer to decide to pay off the bond early if they see the opportunity to refinance at a lower rate. Your client might have done this with their home mortgage. On long term municipal bonds, 10-year call protection has been common. The price they pay off at is usually a slight premium, The $10,000 bond might be called at $10,200.

How do you know the issuer will have the cash to pay everyone off at maturity? Good question. Some bonds have sinking funds. A certain percentage of the bonds are retired each year over a several year period, reducing the amount they need to pay off on the last day. When your client makes a payment on their mortgage, their payment is usually part interest and part principal.

Some bonds have an Early Redemption Provision. This gives the issuer the opportunity to pay the bond off early if they like. 

All these features should be clearly spelled out in the description of the bond.

Consider a bond a contract that ties up your client’s money. The longer it runs (20, 30 years) the higher the rate of interest.

Interest rates move in cycles. Existing bonds paying a higher amount of interest are worth more in a declining interest rate environment. The reverse holds true in a rising rate environment, if a client chooses to sell. These transaction prices are often not face value. They are higher or lower. They are quoted at their yield to maturity (YTM) to make comparison easier. Gains or losses on bonds sold before maturity are subject to tax treatment.

Bond trading has traditionally been a lucrative business for Wall Street. Many stocks are traded on exchanges with posted prices. Bonds are largely traded Over the Counter. Firms make a market by keeping an inventory, buying and selling like a store. It’s like wholesale and retail. They make their money from the markup, not by charging commissions.

Bonds typically pay interest at six-month intervals. The bond you own doesn’t know when you bought it. It pays out the agreed amount every six months. When you buy a bond on the secondary market, you pay accrued interest or the amount earned by the seller for the period of time they owned the bond since the last interest payment.

The best way to buy bonds is when they are initially created and offered for sale. You’ve heard of IPOs. This is done by investment banks and the bonds themselves are distributed through a syndicate of financial services firms. Bonds should ideally be held to maturity.  If you sell before the maturity date, you are getting into the wholesale and retail secondary market.

What should clients do if they want income but don’t want to tie up money too long? They often build a ladder of bonds. For example, an investor wanting to put $ 100,000 to work might buy $ 20,000 each of five bonds at 1,2,3,4 and 5-year intervals. Something is always coming due soon. If they don’t need the money, they add a new five-year bond when the one-year bond matures.

Compared to buying stocks, bonds are easier to understand. Professionals and institutions buy them with the intent of holding them to maturity. There’s basically no cost, except account fees charged by the firm holding them, like rent on a storage unit.

There are many ways bonds are packaged. Mutual funds hold and actively manage a portfolio. They have the advantages of paying monthly income and the reinvesting the proceeds, but the exact return isn’t specified. It varies by what’s in the portfolio. The fund takes a percentage for managing the assets. Separately managed accounts, for larger amounts of money, do something similar.  Unit Investment Trusts hold a specific group of bonds. You know what you are buying, you know your expected income.  You have the ability to reinvest. There are usually fees built in on the front end, but no fee for active management.

Insurance products like annuities can also provide income. Preferred stock is another source. Certain stocks like Utilities and Real Estate Investment Trusts (REITs) are designed for investors seeking income. Mortgages come packaged as bonds, returning both principal and interest (which can be quite a surprise).

This article fills you in on the basics of fixed income, specifically bonds, so you can have an informed conversation with your client.  There’s more to know.  You should study up.

Replies (4)

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Brett Layton, CPA
By bltaxes
Nov 4th 2019 20:19

This is a real danger zone when clients start investing in low quality ETFs, REITs, Preferreds, etc.

The desire for yield is compelling. We need to remind clients that they do not get a return without taking a risk.

I remember seeing several Mortgage REITs go bust in the last recession. Those 10% cash yields went to zero...

Those that do not have a lot of capital to supplement their Social Security and do not have health or ability to work part-time are particularly at risk.

I do not give investment advice, but try to stress that quality of the issuer is important.

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Replying to bltaxes:
Bryce Sanders
By Bryce Sanders
Nov 11th 2019 14:57

BLTaxes, you make very good points. That's why ratings from rating agencies are important, although even that wasn't foolproof 10+ years ago when those mortgage backed bonds had serious problems. In many ways bonds are supposed to be a "shock absorber" in a balanced portfolio, to help smooth volatility. I see your point. Client should realize if something sounds too good to be true (yield) it's often a problem waiting to happen.

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By MarkConner
Nov 6th 2019 21:59

Pretty good job. One comment: It is not correct to say that buying bonds when they are initially issued is the best way to go, this is a common misconception, often engendered by broker sales pitches (brokers are urged by their firms to "participate" in new deals and often the sales commissions are more generous than on secondary market trades.)

1. On any trading day that a new issue of bonds is offered there are numerous other, highly similar bonds (in some cases nearly identical) that are offered by dealers in the secondary market and often at prices that make them very competitive with any new offerings. In fact, because secondary market offerings must compete for investor dollars with any new issues, it is common to find better deals.

2. It is mistakenly believed that there are no mark-ups on bonds when they are newly issued. Not so. In an underwriting of new bonds, the issue is purchased in whole by the underwriting syndicate of dealers and then re-sold at a marginally higher price to investors. Moreover, this mark-up can be greater than on secondary market purchases.

3. Waiting around for new issues before investing is like catching a falling knife. Bond issuers do they best they can to come to market when rates are lower rather than higher. Waiting for new issues can be a fool's game.

4. There is an additional mistaken belief that there is some value in buying bonds at the common new issue offering price of par (100), rather than at a discount or premium to par. This is simply not so. The metric to focus on when making any bond purchase is the "yield to maturity." This total return measure is the great leveler of returns on bonds.

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Replying to MarkConner:
Bryce Sanders
By Bryce Sanders
Nov 11th 2019 15:05

Mark, you make very good points. My point about buying a Municipal or Corporate Bond as an IPO is that it's pretty close to wholesale. If you can get them, it should be the same price as everyone else, until it breaks syndicate and the bonds trade in the secondary market.

You bring up a good point you can shop around for bonds in the secondary market. The challenge is, unlike stocks, very few are listed securities. They are bought through the trading desks and inventory held by financial services firms. The buyer of $ 25 million of a bond will get a better price (spread) than the buyer of $ 25,000 of a bond. Ideally, a financial advisor, working in their client's best interest, would seek to narrow the spread.

You bring up another point re: yield to maturity. I hesitated going there because it's a complex topic, probably beyond the scope of a basic article. When talking about municipal bonds, the issue is clouded by the portion of the return that's tax free (interest) and the portion that's taxable, ie: the discount to par value that contributes to the client's yield to maturity.

You have brought up important points people offering comprehensive advice on bonds needs to know.

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