Judging from our e-mails, it’s clear that investors who are new to the tax-free bond market are preoccupied with rising interest rates. Actually, it would be more accurate to say the prospect of rising interest rates. Not surprisingly, despite the dire warnings of the financial media and Wall Street economists, rates on long-term municipal bonds have been either stable or trending down for some time.
Yet we agree with those who predict that interest rates will rise, just as we agree with those who think they will decline. Because over long periods of time, this is what interest rates do.
Veteran municipal bond investors recognize that obsessing over the future direction of interest rates is counter-productive to the long-term performance of their bond portfolios. These sorts of prognostications are impossible to make with any degree of accuracy.
Check out “The Wall Street Journal’s” year-end poll of economists regarding interest rate predictions over the last 20 years. You will find that the majority of these “experts” are wrong most of the time. Our own files contain correspondence dating back to 1994 predicting the bond market’s demise.
Paying to Wait
As a matter of fact, we began our Cost of Waiting series in June 2001 motivated by similar prophecies. If long-term tax-free bond rates went to 8% tomorrow, it would take over 18 years to make up the income sacrificed by parking funds in the money market for the past two years.
Interest rates move in cycles, usually in concert with the business cycle and inflation. For 30 years, our investors have been successful throughout these cycles by buying the most tax-free income (long bonds) when their investment funds are available. This allows more reinvestable income if rates do move up.
Keep in mind, we don’t recommend that 100% of our clients’ funds be invested in tax-free bonds. Diversification – genuine diversification – is always a valid principle.
In the period between 1979 and 1981, interest rates rose to levels never seen before or since. Long-term bonds, although depressed in value, continued to produce more reinvestable income than shorter-term securities purchased at the same time.
Further, by owning tax-free bonds, investors were able to establish tax losses, maintain their position in the bond market, while at the same time take tax-free capital gains in their investments that responded positively in this period of high inflation. The flexibility of long-term bonds added considerably to their yield even through the worst bond market in history. Then, as is always the case, high rates stalled the economy, leading to lower rates.
We believe the focus on interest rate direction by new investors is a product of the financial media, whose orientation and interest continues to be the stock market. Many prominent journalists have unabashedly confessed to us that they just don’t find bond investing very exciting and, try as we might, we can’t convince them that the approach to stocks and bonds should be different. Buy low/sell high is not the goal of bond investors.
Our investors devote a specific portion of their investment portfolio to tax-free bonds. Without over-thinking the subject, they buy bonds when funds become available (regardless of their thoughts about the future direction of interest rates) and routinely reinvest the income.
Today, for example, an investor can buy AA insured municipal bonds yielding 5.00%. To an investor paying taxes at a 33% rate, this 5.00% tax-free is comparable to earning 7.46% on a taxable security.
As boring as it may be, our investors are pleased to receive their interest checks every six months to reinvest at prevailing rates. Over the course of this long-term investment, interest rates will certainly fluctuate, but it doesn’t matter. They will not be selling their bonds. Their goal is to maintain a steady stream of tax-free income, not produce capital gains.
Different Markets
As long as we are on the subject, it is also important to distinguish between bond markets. Long-term munis are nowhere near historical lows when compared to long-term Treasury bonds, which currently yield approximately 4.90%.
For the record, we think that a stable, low-interest rate environment could persist for years to come. But we’re comforted by the fact that long-term investors will spend their time either working in their own field of expertise or perfecting their golf game, not glued to CNBC or riveted to the Journal waiting to find out.