What I Learned About Bond Accounting

I wrote a post about a week ago (I always wanted to say that!), about municipal bonds, in this case those used to finance Miami International Airport.

Well, during my research I learned something about how investment managers and brokers report the yield on bonds that is somewhat deceptive from an accounting point of view.

To illustrate, the stated yield on the Muni bonds I was looking into was about 3.8% which makes them attractive in the current super low yield environment. However, when you dig into the way the reporting is done, you find out that that 3.8% isn’t accurate at all and the real yield is closer to 1.5%. How? They’re not accounting for the changes in price of the bond at purchase. Let me illustrate as simply as I can

Most bonds are issued at $100 par or face value, but you buy them either at a discount, or at a premium to that value. So you could buy a $100 face value bond with 4% interest rate and a 4 year duration at $110.  Because the par value is $100, your yearly interest will be $4. Under the current standard Muni yield reporting, your broker will report your annual yield as $4 divided by the $110 you paid, which amounts to say 3.6%. The reason this is accurate however, is that your yield is calculated with an assumption that you hold the bond to maturity. And since the bond has a face value of $100, after four years, that’s what you get back, not the $110 principal you paid. So, you’re losing $10 in your invested principal, but gaining $16 in interest payments ($4 for 4 years), which is a net of $6. $6 in four years gives you $1.50 annually, which is a 1.5% annual yield on the $100 bond.

That is the more accurate number. Why don’t they report it that way? I don’t know. But its another way to illustrate that accounting reality is not economic reality, something to keep in mind as you parse different securities for potential investments.

 

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