A rejuvenated economy, induced by the Fed’s bond-buying binge, will ignite inflation and spark a rise in interest rates.
Sound familiar?
It’s a refrain we’ve heard since the Fed launched its quantitative easing program back in 2008.
Ironically, however, recent discussions among Fed governors aren’t focused on how to curb rising prices. Instead, their concern is with disinflation – even deflation – and the inability to spur growth.
The interest-rate seers have been wrong
Despite the Fed’s massive bond-buying program and its continued efforts to hold down its target interest rate, the economy remains anemic, with growth and inflation falling well short of expectations.
That, in turn, has prompted the Fed to keep its foot on the gas. In fact, the Fed will continue to hold down its target interest rate even after ending its bond-buying program, Chairman Ben Bernanke said in a recent speech to economists.
“The target for the federal funds rate is likely to remain near zero for a considerable time after the asset purchases end,” he said, speculating that it could remain low “perhaps well after” the unemployment rate hits the Fed’s 6.5% threshold.
Waiting for the magical day
This scenario contrasts sharply with the legion of prognosticators who for more than a decade have predicted an interest-rate Armageddon, which has prompted some investors to avoid buying municipal bonds – and forgoing the attractive tax-free income they offered – in fear of missing out on that magical day when rates would rise.
Unfortunately, the pundits never specified which bond rates investors should monitor (Treasuries, Corporates, Agencies, Municipals, etc.) or the level they needed to reach before investors committed their funds. They offered no guidance on how waiting for these unknowable signals could affect an investor’s individual investment objectives.
Nevertheless, many investors took heed of the dire warnings and tried to outsmart the market, parking money in money-market funds or CDs, where it has proven to be impossible to recover the income they forfeited while waiting. Others opted to construct a laddered portfolio and have been forced to reinvest their maturing bonds at lower and lower yields, while never capturing the income provided by the higher rates on longer term bonds.
As sure as summer follows spring, Treasury bond rates will rise one day. Equally certain is that trying to determine the precise time is a futile and unprofitable exercise.
Municipal bonds are unique
Successful muni investors know that maximizing tax-free income on every purchase produces more reinvestable income, which can enhance their portfolio’s yield if rates do rise.
Today, the mass liquidation of muni-bond fund shares has resulted in higher yields, which should provide greater protection against price declines if Treasury rates rise. Munis typically trade at a ratio to Treasuries of approximately 90%. Today, this ratio is more than 110%. Concerns, therefore, among municipal bond holders of inflation and higher interest rates may be significantly overblown.
Improved credit quality
The municipal bond market, despite media focus on the Detroit bankruptcy, has seen continued improvement in the credit quality of issuers. Considering the fiscal challenges they faced, issuers have demonstrated remarkable strength and resiliency. Indeed, local and state tax revenues have risen for 14 straight quarters.
What you can control
Municipal bonds have served as a simple and fundamental element of a sound portfolio. But attempting to guess the timing and direction of various economic indicators is folly. Worse, it impedes your primary goal as a municipal bond investor: maximizing your dependable, reinvestable stream of tax-free income. In our experience, the most successful municipal bond investors purchase high quality, long-term bonds whenever investable funds are available and leave market timing to stock pickers.