Vinnie,
Markets have gone crazy as the seasonal flood of new money comes into them. When that happens, I stand aside and do others things, like build spreadsheets. So I spent the afternoon checking my estimate of the impact of taxes and inflation on that AFGC bond.
Assumptions: The bond was bought 12/31/2025 at its closing price of $19.18. The bond caries a 5.125% coupon and comes due in 2059 at par $25. The tax-rate on ordinary-income is 25%. The tax-rate on cap-gains is 15%. The forward inflation-rate will average 6%.
Note: I couldnāt care less about what the US Bureau of Economic Propaganda (aka, the Bureau of Labor Statistics) says the inflation-rate was or will be. At the household level of most people, 6% is probably an under-stated guess. But itās probably close enough to the actual rise in prices most people are experiencing across the basket of goods and services they are trying to afford.
So, this is the question to be explored: āHow soon does the bond provide a negative return?ā
A bond with a par of $25 and a 5.125% coupon provides an annual dividend of $1.28, which gets cut to $0.96 cents due to taxes and has to be further discounted the first year to $0.91 cents due to inflation and to just $0.34 cents in the 18th year.
Explanation: Oneās resulting purchasing-power from the after-tax div in any year subsequent to the purchasing year is the original div multiplied by the reciprocal of the inflation-rate raised to the power of the holding-period.
In the 18th year of owing that bond, the net-sum after taxes and inflation of all divs received will be $10.40. Letās assume the issuer calls the bond that same year at yearās end. The bond-holder will receive a one-time, pre-tax cap-gain of $5.82, but net only $4.95 after taxes, and that amount has to be discounted by 18 years of inflation, giving it a market place, purchasing-power of just $1.73 cents.
Now do the math. The would-be owner spent $19.18 cents of 2025 purchasing-power to buy a bond that put a spendable stream of divs into his or her pocket that took 18 years to total $10.40, and he/she received a one-time cap-gain whose effective, after-taxes and after-inflation purchasing-power in that 18th year was $1.73.
If P/L = Gains minus Cost divided by Cost, then result is negative. In short, buying that long-dated bond was trading elephants for rabbits. Initially, it provided a spendable income-stream. But by the 18th year of owning it, āassuming a callā the spendable gains from the bond have melted away ālike snow upon the desertās dusty faceā (to quote the poet). If held to maturity, the net-loss āon an after-taxes, after-inflation basisā is (-11%). Necessary conclusion? Donāt buy wasting assets, which is what bonds are unless they are bought at a sufficient discount and can be put before the tax and inflation erosions become overwhelming.
Standard Disclaimers: Every one of my assumptions could and should be challenged. Also, I own a lot of long-dated bonds. So this exercise isnāt merely academic, but reflects mistakes I made many years ago by not running the numbers more carefully before I bought.
āSo, what to do? Nothing.ā The situation is unsalvageable, but also non-consequential. As long as the bonds continue to perform, they will provide an income-stream. Not much of an income-stream, nor a needed one. So Iāll allow them to ride and let my heirs deal with the problem. I would say this though. If long-dated bonds are to be bought, buy those most likely to be called, which is a post for another time.