“I currently have a sizable bond portfolio that has a good profit. My current broker has advised me to let a bond specialist manage the fund and take some of the profit off the table. The specialist is going to charge me 80 basis points per year as a management fee. My question is: if I have a few bonds that have a call date of mid ’06, should I take the profit and allow the repurchase of replacement bonds that will have a lower percentage rate, which reduces my income, or do I sit tight and hope they don’t get called and hope the profit is still there?”
C.C., California
This e-mail raises several issues that are important to bond buyers.
First, the question of “bond management.”
We are not proponents of professional management for municipal bond portfolios, and the reason is simple: We have never seen an actively managed fund that out-performed the bonds themselves.
In our experience, the most successful bond investors are those who apply a simple “buy and hold” strategy sprinkled with a dose of common sense. Judging from this investor’s e-mail, he’s been successful on his own, which raises the question: Why change course now?
Although a charge of 80 basis points to manage the portfolio may not appear significant, it becomes substantial in the context of a security that today may return between 4.50% to 5%; 80 basis points represents 16% of the income on a 5% bond. The real damage, however, comes from the hidden transactional costs in an “overmanaged” portfolio, which don’t appear on your statement.
Bonds are not stocks
The second important issue raised in the e-mail is the concept of profits.
Taking profits is usually associated with the stock market. It rarely has a place in the management of bonds. By selling bonds and “taking profits,” you will be subject to capital gains taxes and will be unable to replace the income. Remember, if you are buying new bonds with the sale proceeds, the only money you are taking off the table is the check you will be sending to Uncle Sam.
Based on similar logic, bonds should not be sold simply because they are nearing their call date. The market price on these bonds will be lowered to reflect the fact they can be called in the near future. This means you will be sacrificing a substantial income stream at a fire sale price.
The fact that bonds are callable doesn’t necessarily mean they will be called. There are numerous variables that discourage issuers from redeeming their bonds. We advise clients to keep the bonds until they are forced to surrender them.
Pre-refunded bonds
Contrary to bonds that are merely callable, issues that are pre-refunded (advance refunded) to a call date several years into the future are a different story. When a bond is pre-refunded (refinanced), its maturity date is shortened to the call date and the quality is enhanced because the bond to be refunded is generally escrowed in Treasury bonds. This causes a dramatic rise in the bond’s value, along with a commensurate drop in yield per dollar invested.
When bonds are advance-refunded, there is usually ample time to find a satisfactory replacement since most pre-refundings occur several years prior to the actual call date. We recommend replacing bonds in these instances if an investor can buy more yield on new bonds than he is earning on the pre-refunded security.
It’s really simple
Muni bond investing is really quite simple: invest when you have the funds and then let the bonds do their job – generate income. Though it’s helpful to consult with a bond specialist to select the bonds that are right for you, the so-called management of your bond portfolio should stop there.