Back in the late ’70s and early ’80s when the inflation rate soared to levels not seen since the end of World War I, then-Chairman of the Federal Reserve Paul Volcker ratcheted interest rates up to the point where one-month jumbo CDs were yielding over 20% and 30-year Treasuries were yielding about 14%. He did this to break the back of inflation that had risen into double digits and was wreaking havoc on the value of stocks, bonds, and currency. Volcker’s tactics worked—but not before sending mortgage rates above 14%, causing great pain for the average borrower. In time inflation fell into the low single digits where it has remained to this day.
People who purchased some of these long-term Treasury bonds in the ’80s and ’90s and held on to them to this day are the owners of very highly appreciated assets because as interest rates go down the underlying value of the bonds goes up. To illustrate consider the following:
The Treasury, a bank, or a corporation issues a $100,000 bond yielding 10%, $10,000 a year, for a number of years. Assume that after a while interest rates go down and now the yield on a similar bond is only 5%. How much would the first bond with a 10% yield be worth in the marketplace now?
The answer is about $200,000, because it would take that amount at a 5% yield to generate the $10,000 a year that the bond is producing.
This is a simplistic illustration because bonds are very complicated and many factors enter into their valuation (e.g., time to maturity, credit worthiness of the issuing entity, etc.).
The converse is also true: As interest rates go up, the value of the underlying bond goes down. And most knowledgeable people on Wall Street believe that (as the economy continues its healing process) interest rates are headed higher.
If you own bonds purchased long ago when interest rates were higher, your profit in these bonds will dissipate as interest rates rise. The same will happen as time passes and the bond approaches its maturity date because the issuing entity is only obligated to pay you the face amount of the bond. So if it was issued and you paid $1,000 for it and it’s now worth $1,100, at maturity you will get back the original $1,000.
If you were to sell the bond, you will indeed lock in your profit of $100, but you’ll also have to pay capital-gain tax.
A gift of an appreciated bond to support our work will avoid capital-gain taxation on your profit and provide you with a charitable income-tax deduction for its full fair-market value. An appreciated bond is also a great asset for making a gift that will return income to you for life—commonly referred to as a life-income gift. Contact us to discuss how you could benefit from this type of arrangement.