The choice of issues in the bond component of the investor’s portfolio will turn about two main questions: Should he buy taxable or tax-free bonds, and should he buy shorter- or longer-term maturities? The tax decision should be mainly a matter of arithmetic, turning on the difference in yields as compared with the
investor’s tax bracket. In January 1972 the choice in 20-year maturities was between obtaining, say, 71⁄ 2% on “grade Aa” corporate bonds and 5.3% on prime tax-free issues. (The term “municipals” is generally applied to all species of tax-exempt bonds, including state obligations.) There was thus for this maturity a loss in income of some 30% in passing from the corporate to the municipal field.
Hence if the investor was in a maximum tax bracket higher than 30% he would have a net saving after taxes by choosing the municipal bonds; the opposite, if his maximum tax was less than 30%. A single person starts paying a 30% rate when his income after deductions passes $10,000; for a married couple the rate applies when combined taxable income passes $20,000. It is evident that a
large proportion of individual investors would obtain a higher return after taxes from good municipals than from good corporate bonds.
The choice of longer versus shorter maturities involves quite a different question, viz.: Does the investor want to assure himself against a decline in the price of his bonds, but at the cost of (1) a lower annual yield and (2) loss of the possibility of an appreciable gain in principal value? For a period of many years in the past the only sensible bond purchases for individuals were the U.S. savings issues. Their safety was—and is—unquestioned; they gave a higher return than other bond investments of first quality; they had a money-back option and other privileges which added greatly to their attractiveness. In our earlier editions we had an entire chapter entitled “U.S. Savings Bonds: A Boon to Investors.”
As we shall point out, U.S. savings bonds still possess certain unique merits that make them a suitable purchase by any individual investor. For the man of modest capital—with, say, not more than $10,000 to put into bonds—we think they are still the easiest and the best choice. But those with larger funds may find other
mediums more desirable.
Let us list a few major types of bonds that deserve investor consideration, and discuss them briefly with respect to general description, safety, yield, market price, risk, income-tax status, and other features.
1. u.s. savings bonds, series e and series h. We shall first summarize their important provisions, and then discuss briefly the numerous advantages of these unique, attractive, and exceedingly convenient investments. The Series H bonds pay interest semiannually, as do other bonds. The rate is 4.29% for the first year, and then a flat 5.10% for the next nine years to maturity. Interest on the Series E bonds is not paid out, but accrues to the holder through increase in redemption value. The bonds are sold at 75% of their face value, and mature at 100% in 5 years 10 months after purchase. If held to maturity the yield works out at 5%, compounded semiannually. If redeemed earlier, the yield moves up from a minimum of 4.01% in the first year to an average of 5.20% in the next 45⁄ 6 years.
Interest on the bonds is subject to Federal income tax, but is exempt from state income tax. However, Federal income tax on the Series E bonds may be paid at the holder’s option either annually as the interest accrues (through higher redemption value), or not until the bond is actually disposed of.
Owners of Series E bonds may cash them in at any time (shortly after purchase) at their current redemption value. Holders of Series H bonds have similar rights to cash them in at par value (cost).
Series E bonds are exchangeable for Series H bonds, with certain tax advantages. Bonds lost, destroyed, or stolen may be replaced without cost. There are limitations on annual purchases, but liberal provisions for co-ownership by family members make it possible for most investors to buy as many as they can afford.
There is no other investment that combines (1) absolute assurance of principal and interest payments, (2) the right to demand full “money back” at any time, and (3) guarantee of at least a 5% interest rate for at least ten years. Holders of the earlier issues of Series E bonds have had the right to extend their bonds at maturity, and thus to continue to accumulate annual values at successively
higher rates. The deferral of income-tax payments over these long periods has been of great dollar advantage; we calculate it has increased the effective net-after-tax rate received by as much as a third in typical cases. Conversely, the right to cash in the bonds at cost price or better has given the purchasers in former years of low interest rates complete protection against the shrinkage in principal value that befell many bond investors; otherwise stated, it gave
them the possibility of benefiting from the rise in interest rates by switching their low-interest holdings into very-high-coupon issues on an even-money basis.
In our view the special advantages enjoyed by owners of savings bonds now will more than compensate for their lower current return as compared with other direct government obligations.
2. other united states bonds. A profusion of these issues exists, covering a wide variety of coupon rates and maturity dates. All of them are completely safe with respect to payment of interest and principal. They are subject to Federal income taxes but free from state income tax. In late 1971 the long-term issues—over ten years— showed an average yield of 6.09%, intermediate issues (three to five years) returned 6.35%, and short issues returned 6.03%.
In 1970 it was possible to buy a number of old issues at large discounts. Some of these are accepted at par in settlement of estate taxes. Example: The U.S. Treasury 31⁄2s due 1990 are in this category; they sold at 60 in 1970, but closed 1970 above 77.
It is interesting to note also that in many cases the indirect obligations of the U.S. government yield appreciably more than its direct obligations of the same maturity. As we write, an offering appears of 7.05% of “Certificates Fully Guaranteed by the Secretary of Transportation of the Department of Transportation of the United States.” The yield was fully 1% more than that on direct obligations of the U.S., maturing the same year (1986). The certificates were actually issued in the name of the Trustees of the Penn Central Transportation Co., but they were sold on the basis of a statement by the U.S. Attorney General that the guarantee “brings into being a general obligation of the United States, backed by its full faith and credit.” Quite a number of indirect obligations of this sort have been assumed by the U.S. government in the past, and all of them have been scrupulously honored.
The reader may wonder why all this hocus-pocus, involving an apparently “personal guarantee” by our Secretary of Transportation, and a higher cost to the taxpayer in the end. The chief reason for the indirection has been the debt limit imposed on government borrowing by the Congress. Apparently guarantees by the government are not regarded as debts—a semantic windfall for
shrewder investors. Perhaps the chief impact of this situation has been the creation of tax-free Housing Authority bonds, enjoying the equivalent of a U.S. guarantee, and virtually the only taxexempt issues that are equivalent to government bonds. Another type of government-backed issues is the recently created New Community Debentures, offered to yield 7.60% in September 1971.
3. state and municipal bonds. These enjoy exemption from Federal income tax. They are also ordinarily free of income tax in the state of issue but not elsewhere. They are either direct obligations of a state or subdivision, or “revenue bonds” dependent for interest payments on receipts from a toll road, bridge, building lease, etc. Not all tax-free bonds are strongly enough protected to justify their purchase by a defensive investor. He may be guided in his selection by the rating given to each issue by Moody’s or Standard & Poor’s. One of three highest ratings by both services—Aaa (AAA), Aa (AA), or A—should constitute a sufficient indication of adequate safety. The yield on these bonds will vary both with the quality and the maturity, with the shorter maturities giving the lower return. In late 1971 the issues represented in Standard & Poor’s municipal bond index averaged AA in quality rating, 20 years in maturity, and 5.78% in yield. A typical offering of Vineland, N.J., bonds, rated AA for A and gave a yield of only 3% on the one-year maturity, rising to 5.8% to the 1995 and 1996 maturities.
4. corporation bonds. These bonds are subject to both Federal and state tax. In early 1972 those of highest quality yielded 7.19% for a 25-year maturity, as reflected in the published yield of Moody’s Aaa corporate bond index. The so-called lower-medium-grade issues—rated Baa—returned 8.23% for long maturities. In each class shorter-term issues would yield somewhat less than
longer-term obligations.
The above summaries indicate that the average investor has several choices among high-grade bonds. Those in high income-tax brackets can undoubtedly obtain a better net yield from good tax-free issues than from taxable ones. For others the early 1972 range of taxable yield would seem to be from 5.00% on
U.S. savings bonds, with their special options, to about 71⁄2% on high-grade corporate issues.
Higher-Yielding Bond Investments
By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they
expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default. (It is true that bargain opportunities occur fairly often in lower-grade bonds, but these require special study and skill to exploit successfully.)
Perhaps we should add here that the limits imposed by Congress on direct bond issues of the United States have produced at least two sorts of “bargain opportunities” for investors in the purchase of government-backed obligations. One is provided by the tax-exempt “New Housing” issues, and the other by the recently created (taxable) “New Community debentures.” An offering of New Housing issues in July 1971 yielded as high as 5.8%, free from both Federal and state taxes, while an issue of (taxable) New Community debentures sold in September 1971 yielded 7.60%. Both obligations have the “full faith and credit” of the United States government behind them and hence are safe without question.
And—on a net basis—they yield considerably more than ordinary United States bonds.
Savings Deposits in Lieu of Bonds
An investor may now obtain as high an interest rate from a savings deposit in a commercial or savings bank (or from a bank certificate of deposit) as he can from a first-grade bond of short maturity. The interest rate on bank savings accounts may be lowered in the future, but under present conditions they are a suitable substitute for short-term bond investment by the individual.
Convertible Issues
These are discussed in Chapter 16. The price variability of bonds in general is treated in Chapter 8, The Investor and Market Fluctuations.
Call Provisions
In previous editions we had a fairly long discussion of this aspect of bond financing, because it involved a serious but little noticed injustice to the investor. In the typical case bonds were callable fairly soon after issuance, and at modest premiums—say 5%—above the issue price. This meant that during a period of wide fluctuations in the underlying interest rates the investor had to bear the full brunt of unfavorable changes and was deprived of all but a meager participation in favorable ones.
Example: Our standard example has been the issue of American Gas & Electric 100-year 5% debentures, sold to the public at 101 in 1928. Four years later, under near-panic conditions, the price of these good bonds fell to 621⁄2, yielding 8%. By 1946, in a great reversal, bonds of this type could be sold to yield only 3%, and the 5% issue should have been quoted at close to 160. But at that point the company took advantage of the call provision and redeemed the issue at a mere 106.
The call feature in these bond contracts was a thinly disguised instance of “heads I win, tails you lose.” At long last, the bond-buying institutions refused to accept this unfair arrangement; in recent years most long-term high-coupon issues have been protected against redemption for ten years or more after issuance. This still limits their possible price rise, but not inequitably.
In practical terms, we advise the investor in long-term issues to sacrifice a small amount of yield to obtain the assurance of noncallability—say for 20 or 25 years. Similarly, there is an advantage in buying a low-coupon bond* at a discount rather than a high-coupon bond selling at about par and callable in a few years. For the discount—e.g., of a 31⁄ 2% bond at 631 ⁄ 2%, yielding 7.85%—carries
full protection against adverse call action.
investor’s tax bracket. In January 1972 the choice in 20-year maturities was between obtaining, say, 71⁄ 2% on “grade Aa” corporate bonds and 5.3% on prime tax-free issues. (The term “municipals” is generally applied to all species of tax-exempt bonds, including state obligations.) There was thus for this maturity a loss in income of some 30% in passing from the corporate to the municipal field.
Hence if the investor was in a maximum tax bracket higher than 30% he would have a net saving after taxes by choosing the municipal bonds; the opposite, if his maximum tax was less than 30%. A single person starts paying a 30% rate when his income after deductions passes $10,000; for a married couple the rate applies when combined taxable income passes $20,000. It is evident that a
large proportion of individual investors would obtain a higher return after taxes from good municipals than from good corporate bonds.
The choice of longer versus shorter maturities involves quite a different question, viz.: Does the investor want to assure himself against a decline in the price of his bonds, but at the cost of (1) a lower annual yield and (2) loss of the possibility of an appreciable gain in principal value? For a period of many years in the past the only sensible bond purchases for individuals were the U.S. savings issues. Their safety was—and is—unquestioned; they gave a higher return than other bond investments of first quality; they had a money-back option and other privileges which added greatly to their attractiveness. In our earlier editions we had an entire chapter entitled “U.S. Savings Bonds: A Boon to Investors.”
As we shall point out, U.S. savings bonds still possess certain unique merits that make them a suitable purchase by any individual investor. For the man of modest capital—with, say, not more than $10,000 to put into bonds—we think they are still the easiest and the best choice. But those with larger funds may find other
mediums more desirable.
Let us list a few major types of bonds that deserve investor consideration, and discuss them briefly with respect to general description, safety, yield, market price, risk, income-tax status, and other features.
1. u.s. savings bonds, series e and series h. We shall first summarize their important provisions, and then discuss briefly the numerous advantages of these unique, attractive, and exceedingly convenient investments. The Series H bonds pay interest semiannually, as do other bonds. The rate is 4.29% for the first year, and then a flat 5.10% for the next nine years to maturity. Interest on the Series E bonds is not paid out, but accrues to the holder through increase in redemption value. The bonds are sold at 75% of their face value, and mature at 100% in 5 years 10 months after purchase. If held to maturity the yield works out at 5%, compounded semiannually. If redeemed earlier, the yield moves up from a minimum of 4.01% in the first year to an average of 5.20% in the next 45⁄ 6 years.
Interest on the bonds is subject to Federal income tax, but is exempt from state income tax. However, Federal income tax on the Series E bonds may be paid at the holder’s option either annually as the interest accrues (through higher redemption value), or not until the bond is actually disposed of.
Owners of Series E bonds may cash them in at any time (shortly after purchase) at their current redemption value. Holders of Series H bonds have similar rights to cash them in at par value (cost).
Series E bonds are exchangeable for Series H bonds, with certain tax advantages. Bonds lost, destroyed, or stolen may be replaced without cost. There are limitations on annual purchases, but liberal provisions for co-ownership by family members make it possible for most investors to buy as many as they can afford.
There is no other investment that combines (1) absolute assurance of principal and interest payments, (2) the right to demand full “money back” at any time, and (3) guarantee of at least a 5% interest rate for at least ten years. Holders of the earlier issues of Series E bonds have had the right to extend their bonds at maturity, and thus to continue to accumulate annual values at successively
higher rates. The deferral of income-tax payments over these long periods has been of great dollar advantage; we calculate it has increased the effective net-after-tax rate received by as much as a third in typical cases. Conversely, the right to cash in the bonds at cost price or better has given the purchasers in former years of low interest rates complete protection against the shrinkage in principal value that befell many bond investors; otherwise stated, it gave
them the possibility of benefiting from the rise in interest rates by switching their low-interest holdings into very-high-coupon issues on an even-money basis.
In our view the special advantages enjoyed by owners of savings bonds now will more than compensate for their lower current return as compared with other direct government obligations.
2. other united states bonds. A profusion of these issues exists, covering a wide variety of coupon rates and maturity dates. All of them are completely safe with respect to payment of interest and principal. They are subject to Federal income taxes but free from state income tax. In late 1971 the long-term issues—over ten years— showed an average yield of 6.09%, intermediate issues (three to five years) returned 6.35%, and short issues returned 6.03%.
In 1970 it was possible to buy a number of old issues at large discounts. Some of these are accepted at par in settlement of estate taxes. Example: The U.S. Treasury 31⁄2s due 1990 are in this category; they sold at 60 in 1970, but closed 1970 above 77.
It is interesting to note also that in many cases the indirect obligations of the U.S. government yield appreciably more than its direct obligations of the same maturity. As we write, an offering appears of 7.05% of “Certificates Fully Guaranteed by the Secretary of Transportation of the Department of Transportation of the United States.” The yield was fully 1% more than that on direct obligations of the U.S., maturing the same year (1986). The certificates were actually issued in the name of the Trustees of the Penn Central Transportation Co., but they were sold on the basis of a statement by the U.S. Attorney General that the guarantee “brings into being a general obligation of the United States, backed by its full faith and credit.” Quite a number of indirect obligations of this sort have been assumed by the U.S. government in the past, and all of them have been scrupulously honored.
The reader may wonder why all this hocus-pocus, involving an apparently “personal guarantee” by our Secretary of Transportation, and a higher cost to the taxpayer in the end. The chief reason for the indirection has been the debt limit imposed on government borrowing by the Congress. Apparently guarantees by the government are not regarded as debts—a semantic windfall for
shrewder investors. Perhaps the chief impact of this situation has been the creation of tax-free Housing Authority bonds, enjoying the equivalent of a U.S. guarantee, and virtually the only taxexempt issues that are equivalent to government bonds. Another type of government-backed issues is the recently created New Community Debentures, offered to yield 7.60% in September 1971.
3. state and municipal bonds. These enjoy exemption from Federal income tax. They are also ordinarily free of income tax in the state of issue but not elsewhere. They are either direct obligations of a state or subdivision, or “revenue bonds” dependent for interest payments on receipts from a toll road, bridge, building lease, etc. Not all tax-free bonds are strongly enough protected to justify their purchase by a defensive investor. He may be guided in his selection by the rating given to each issue by Moody’s or Standard & Poor’s. One of three highest ratings by both services—Aaa (AAA), Aa (AA), or A—should constitute a sufficient indication of adequate safety. The yield on these bonds will vary both with the quality and the maturity, with the shorter maturities giving the lower return. In late 1971 the issues represented in Standard & Poor’s municipal bond index averaged AA in quality rating, 20 years in maturity, and 5.78% in yield. A typical offering of Vineland, N.J., bonds, rated AA for A and gave a yield of only 3% on the one-year maturity, rising to 5.8% to the 1995 and 1996 maturities.
4. corporation bonds. These bonds are subject to both Federal and state tax. In early 1972 those of highest quality yielded 7.19% for a 25-year maturity, as reflected in the published yield of Moody’s Aaa corporate bond index. The so-called lower-medium-grade issues—rated Baa—returned 8.23% for long maturities. In each class shorter-term issues would yield somewhat less than
longer-term obligations.
The above summaries indicate that the average investor has several choices among high-grade bonds. Those in high income-tax brackets can undoubtedly obtain a better net yield from good tax-free issues than from taxable ones. For others the early 1972 range of taxable yield would seem to be from 5.00% on
U.S. savings bonds, with their special options, to about 71⁄2% on high-grade corporate issues.
Higher-Yielding Bond Investments
By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they
expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default. (It is true that bargain opportunities occur fairly often in lower-grade bonds, but these require special study and skill to exploit successfully.)
Perhaps we should add here that the limits imposed by Congress on direct bond issues of the United States have produced at least two sorts of “bargain opportunities” for investors in the purchase of government-backed obligations. One is provided by the tax-exempt “New Housing” issues, and the other by the recently created (taxable) “New Community debentures.” An offering of New Housing issues in July 1971 yielded as high as 5.8%, free from both Federal and state taxes, while an issue of (taxable) New Community debentures sold in September 1971 yielded 7.60%. Both obligations have the “full faith and credit” of the United States government behind them and hence are safe without question.
And—on a net basis—they yield considerably more than ordinary United States bonds.
Savings Deposits in Lieu of Bonds
An investor may now obtain as high an interest rate from a savings deposit in a commercial or savings bank (or from a bank certificate of deposit) as he can from a first-grade bond of short maturity. The interest rate on bank savings accounts may be lowered in the future, but under present conditions they are a suitable substitute for short-term bond investment by the individual.
Convertible Issues
These are discussed in Chapter 16. The price variability of bonds in general is treated in Chapter 8, The Investor and Market Fluctuations.
Call Provisions
In previous editions we had a fairly long discussion of this aspect of bond financing, because it involved a serious but little noticed injustice to the investor. In the typical case bonds were callable fairly soon after issuance, and at modest premiums—say 5%—above the issue price. This meant that during a period of wide fluctuations in the underlying interest rates the investor had to bear the full brunt of unfavorable changes and was deprived of all but a meager participation in favorable ones.
Example: Our standard example has been the issue of American Gas & Electric 100-year 5% debentures, sold to the public at 101 in 1928. Four years later, under near-panic conditions, the price of these good bonds fell to 621⁄2, yielding 8%. By 1946, in a great reversal, bonds of this type could be sold to yield only 3%, and the 5% issue should have been quoted at close to 160. But at that point the company took advantage of the call provision and redeemed the issue at a mere 106.
The call feature in these bond contracts was a thinly disguised instance of “heads I win, tails you lose.” At long last, the bond-buying institutions refused to accept this unfair arrangement; in recent years most long-term high-coupon issues have been protected against redemption for ten years or more after issuance. This still limits their possible price rise, but not inequitably.
In practical terms, we advise the investor in long-term issues to sacrifice a small amount of yield to obtain the assurance of noncallability—say for 20 or 25 years. Similarly, there is an advantage in buying a low-coupon bond* at a discount rather than a high-coupon bond selling at about par and callable in a few years. For the discount—e.g., of a 31⁄ 2% bond at 631 ⁄ 2%, yielding 7.85%—carries
full protection against adverse call action.
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