Are you afraid of owning long-term bonds? That’s what we’re hearing from some investors, who are encouraged by their brokers and financial planners to construct short-term bond ladders as a hedge against rising interest rates.
We can’t explain why they’re promoting the concept of bond laddering, because it’s a flawed strategy. Perhaps they feel it lends a degree of sophistication to their presentation, or they enjoy the fact that it produces more client transactions.
The numbers don’t make sense
As we told Bernard Conden of Forbes magazine, we challenge any broker, analyst or numbers cruncher to provide any arithmetical proof that a short-term laddered portfolio has ever outperformed the simple strategy of buying and holding high-quality, long-term municipal bonds. There is no historical data over the last 30 years to support the laddering argument.
Of course, it is important to determine exactly what you are trying to accomplish before you make any investment. If your objective is to maintain constant market value in anticipation of a near-term need for cash, we suggest buying very short-term bonds or parking your funds in a tax-free money market. In this case, your goal is the return of your money, not the return on your money.
But if you have a longer-term horizon and have some degree of risk tolerance, you should be investing in high quality, long-term bonds that maximize tax-free income.
Bond laddering sacrifices more income than you think
One reason the concept of bond laddering has lingered despite its harmful effects on income is a misconception about the difference in interest rates between short term and long-term bonds. For example, if short-term bonds pay 2.50% while long-term bonds pay 4.50%, many would say the difference is only 2%. That is a terrible mistake.
An investor buying $100,000 of 2.50% bonds will earn $2,500 per year, while an investor buying the same amount of 4.50% bonds will earn $4,500 per year. This additional $2,000 represents 80% more annual income than would be earned on the shorter-term bond. And by reinvesting this additional cash flow, the investor can augment the advantage of the higher paying bond even further.
Are you prepared to sacrifice as much as 40% to 50% of your tax-free income on every purchase? Remember, income is why you buy bonds in the first place.
Where will yields go?
Apparently, underlying the recent revival of the concept of laddering is the argument that in today’s lower-interest rate environment, yields couldn’t possibly sink further and have nowhere to go but up.
Today, long-term, high-quality munis can be purchased that yield more than taxable treasury bonds. This has not been their traditional relationship. We believe when it becomes clear that the Bush tax cuts will expire in January, as scheduled, along with the reduced tax-free bond issuance brought about by the Build America Bonds (BABs) program and an economy continuing to de-leverage, we can easily picture the spread between taxable and tax-free bond rates tightening significantly. (For an expanded look at BABs, read our article, “Popularity of BABs Bodes Well for Tax-free Bonds“.)
Trying to predict interest rates has always been an exercise in futility, though that hasn’t stopped the financial gurus who recommend that their clients sacrifice significant income waiting for their prognostications to pan out. As we have said, the cost of waiting can be severe.
Although certain short-term laddering strategies may be appropriate for other fixed-income markets, when it comes to tax-free bonds, this approach sacrifices too much income to be considered anything more than a tax-free savings account.
Returns and safety
Naturally, risk is inherent in any investment. But high-tax bracket investors buy municipal bonds because there is no other vehicle that can provide comparable returns with the same degree of safety. It makes no sense to forego the most attractive aspect of municipal bonds: a steady stream of tax-free cash flow.
The only argument for short-term bonds is that there is less fluctuation in their market value. But this, too, is illusory. True, there is less market volatility with shorter-term bonds, but this is meaningless since bond investors rarely sell their securities.
Veteran municipal bond investors look first to purchase the highest quality bonds available and then to maximize their tax free rate of return, recognizing that over the life of their bonds, they will sometimes be worth more than they paid for them and sometimes less. During the depths of the recent financial crisis many long term bonds lost 20% or more of their market value. Currently, these bonds have more than recovered those temporary losses. Once again, market value was completely irrelevant to the long-term investor, but income was not, as equity investors discovered.
While laddering may look good in a presentation, it doesn’t stand up to real-world experience and the much simpler concept successful investors have used for years: When funds are available, buy high quality, long-term bonds and maximize your steady stream of tax-free income. Leave the market timing to the TV pundits.