The Tyranny Of Mark-To-Market Bond Holdings

by: Rick Ashburn

We take for granted the system of marking all investment holdings to market, every single day. Not true of, say, real estate, but true of darn near everything else.

For assets bearing no maturity date (such as stocks), MTM makes sense. Otherwise, you really don't know what you have. The only way you're ever going to get paid is if someone buys your asset.

For bonds intending to be held to maturity, MTM only leads to erroneous return reporting and poor choices. If an investor owns a bond yielding 5% to maturity, a price increase of 2% in any given year leads him to believe he just made 7%.

He did no such thing. That price increase is temporary, and will be given back over the holding period with absolute certainty. Even if he were to sell the bond and reinvest the 102% of his original capital, it will be reinvested at a lower yield and lead to the same eventual return. Minus taxes and transaction fees, of course.

Back "in the day" bonds intended to be held to maturity were carried at book value. Book value accretes discounts and amortizes premiums such that the carrying value of the bond marches steadily toward the original yield to maturity. The entire point of owning bonds in a portfolio is to provide certainty. And, if one manages credit risk properly, bonds do just that. The expected yield at purchase is equal to the yield actually earned on the principal.

It is true that some entities will need to mark bonds to market every day. Banks, insurance companies and mutual funds do not have full control over their liquidity needs and so must compute a liquidating value. But individual investors, endowments and many retirement plans do control their liquidity, or have a predictable liquidity need. These investors should compute their periodic statements and results using the book value, and book return, on bond holdings. These book results should be combined with MTM results in order to maintain a clear and informative view of their progress.

For more thoughts on this, view a video I made on the topic.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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