As most individual investors know, muni bonds are at historic levels. Compared to taxable income securities, there’s never been a better time – and there may never be a better time – to invest in quality tax-free bonds.
Top quality municipal bonds with investment-grade ratings can be purchased today with yields in excess of 6.00% to maturity. An investor in the 35% federal tax bracket would need to receive 9.40% on a taxable security to match this rate of return.
As Randall Forsythe pointed out in a recent Barron’s column, “Investors now can legitimately earn returns roughly equivalent to what Bernie Madoff purported to provide, in real, after-tax terms from top quality municipal bonds.”
An equally compelling reason to buy tax-free bonds today is that the “cost of waiting” has never been higher.
Many individual investors, because of the housing crisis, recession and the catastrophic swoon in stock prices, have deferred their bond purchases, seeking the safety of money market funds. This has caused the yields on these funds to dwindle to almost nothing. (Most tax-free money market funds are paying less than .25%.) At the same time, the recent lack of institutional support for long-term municipal bonds has produced higher yields on these securities.
Cost of waiting
Consider two hypothetical investors. Both are currently in the 35% tax bracket and both have $100,000 earmarked for tax-free bonds.
Investor A has always believed in investing his funds as soon as they become available. He adopted this strategy years ago, after concluding that neither he nor the so-called experts have ever successfully predicted the future direction of interest rates for any sustained period of time.
So he calls his broker and invests $100,000 in bonds yielding 6.00%.
Investor B finds this strategy to be too simplistic. He is convinced that long-term muni rates will continue rising and plans to wait until bonds are yielding 6.50%.
Until the “right time” comes, he will put his money in the tax-exempt money market fund where he will unfortunately earn only .18% while he is waiting.
If 6.50% bonds were to become available in only six months, believe it or not, it will take over six years to catch up to the interest income earned by Investor A.
Do the math
After six years, Investor A’s 6.00% bonds will have produced $36,000. Investor B, with six months of money market interest at .18% plus 6.50% for five years and six months, will have collected only $35,840.
If Investor B has to wait a year for 6.50% bonds, it will take almost 12 years to catch up with Investor A.
Even if a comparable quality bond became available in 12 months yielding 7.00%, it would still take Investor B almost six years to match the income earned over this period. If it were to take two years before Investor B saw his 7.00%, it would then take more than 11 years to equal Investor A’s income.
3,230% more income
The main reason most investors don’t focus on the cost of waiting is they don’t readily pick up on the fact that the difference between .18% and 6.00% is not 5.82%, as it appears at first glance. 6.00% actually produces a whopping 3,230% more income.
By sacrificing this much income, Investor B unwittingly leaves himself at a decided disadvantage as an income investor.
Keep in mind, in the hypothetical scenarios we presented, we granted Investor B’s wish for higher rates. Think of what he’ll be giving up if he’s wrong.
Even if rates on Treasury bonds were to rise, we think there are many factors today which would suggest that muni rates will likely stabilize at these levels or decline.
Remember: Taxes will be rising (making all tax-free bonds more valuable). Institutions will be getting healthier and returning to the market, while at the same time, demographics suggest that an aging population will be demanding more income securities. It may also take a whole new generation before investors are once again willing to trust the stock market with their life savings.
We think Investor B will likely find himself chasing higher bond prices and lower yields, especially if all these ingredients come into the mix at the same time.