FORTUNE -- Investment-grade municipal bonds used to be Snooze City. You know, the kind of thing that we retail investors buy, stick into our portfolios, and then forget about. But these days, thanks to the Federal Reserve's holding down interest rates and the prospect of steeper income taxes facing top-bracket types, high-grade munis, which pay tax-free interest, have become insanely popular. And are a train wreck waiting to happen.
Yes, I know you've heard over and over that bonds have crossed the border into bubble land. And you've seen that the more that people like me point with alarm, the lower the yields fall, the higher the prices of existing bonds climb, the more money retail investors pour into bond funds -- and the sillier pointers-with-alarm look.
Nevertheless, given that this is Fortune's annual investment issue, I want to warn you -- yet again -- about the perils of buying bonds at current prices. You should be especially wary of muni bonds trading at fat premiums above face value.
Here's the deal. Unlike U.S. Treasury securities and many corporate bonds, lots of investment-grade muni bonds can be -- and will be -- called in for early redemption by their issuers. That means that muni bonds' apparent interest yields are way above the actual yield that you'll get if you buy at today's price.
Let's look at a security that I own: a New Jersey transit trust fund bond bought at about face value when it was issued four years ago. This bond, which pays 5.25% annual interest and is due in June 2023, currently trades for 120.505% of face value, according to the most recent Bloomberg quote. On the surface, its yield looks pretty good in these ultra-low-rate days: 4.36%. You get that by dividing the 5.25 of interest by the bond's market value of 120.505.
However, you're not going to get 4.36% on the bond. Why? Because New Jersey is scheduled to redeem it, at 100% of face value, less than 11 years from now. Buy a $10,000 bond for $12,051 today, and in 2023 you'll get back $2,051 less than you paid. That offsets a good part of the interest you'll get over the bond's remaining life. By Bloomberg's math, your "yield to maturity" is only 3.05%. A heck of a lot less than 4.36%.
But wait -- it gets worse. New Jersey has the right to redeem the bond at face value in June 2018, less than six years from now. If rates remain anywhere near their current levels in 2018, this bond will be redeemed fast enough to break the sound barrier. That produces some sorry math: Pay the aforementioned $12,051 for your bond, get redeemed out for $10,000 in 2018, and your "yield to worst," as it's known, is 1.66%. Yechhhh!
Got it? Okay. If you decide to buy a bond fund, carefully analyze the portfolio, which will probably consist largely of bonds selling above face value. If I were you, I'd ask the fund manager not only what the stated yield on the portfolio is, but also what the yield to redemption and the yield to worst are. I suspect that if you get answers to those questions, you'll be unpleasantly surprised.
So am I selling my Jersey bonds? Nope, even though their market prices strike me as insane. Why? Because if I sold, I would have to pay a substantial capital gains tax, and my income from reinvesting the sale proceeds wouldn't come close to matching what the bonds are paying me now. I'll take my profit gradually, in the form of years of higher-than-market interest payments, rather than selling for more than I paid.
But make no mistake: Even though people like me aren't selling, anyone with a bond calculator and a knowledge of financial history knows that investment-grade munis like mine are priced at bubble levels. And that bubbles last longer than you think they will but always pop in the end. And that when boring investments become exciting ones, it's time to keep a firm grip on your emotions -- and on your wallet.
--Reporter associate: Doris Burke
This story is from the December 24, 2012 issue of Fortune.
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