Municipal Bond Forum
Laddering when rates are flat
Q
Your argument against laddering works well in large part because of the environment we have been in (sharply declining rates since 1982). In a bear market for bonds, or in an environment where rates stay relatively flat, it is not nearly as compelling. I suspect the multi-generational bull market in bonds we have had is about over, so a more defensive stance may have more merit going forward.
A
James A. Klotz responds:
This country has never experienced a more negative interest rate environment than existed in the late 1970s and early 1980s. This is why we selected this time period to illustrate the ineffectiveness of laddering municipal bonds in our article on laddering. During this period, 30-year municipal bonds were yielding in excess of 10%.
As a portfolio manager, you know that the municipal yield curve is steeper than the Treasury bond curve, where laddering is more appropriate. Contrary to your suggestion, the muni curve is never “relatively flat.” Extending maturities invariably produces a yield advantage.
Most long-term municipal bond investors recognize how unimportant and misleading “annual total return” can be. Unfortunately, mutual funds and portfolio managers are forced to be overly conscious of year-end values in order to market their services.
Traditional muni investors, on the other hand, accept the fact that over the life of their bonds they will sometimes be worth more than they paid for them, and sometimes less, in accordance with business and interest rate cycles. It is of little concern to them since they rarely sell their securities.
Once they are satisfied with the credit-worthiness of the issue, they attempt to maximize their tax-free income on each purchase. After all, this is why they are buying municipal bonds in the first place. It’s all about the TAX-FREE INCOME, and laddering sacrifices 40% to 50% of it.
If you do the research, you’ll find it tough to find a reasonable period of time (10 years) when a 10-year laddered portfolio outperformed simply buying and holding long-term tax-free bonds.
We have worked with municipal bond investors for the past 37 years. Our strategy of maximizing tax-free income has served them well. It has also eliminated the need for us to play the futile game of trying to predict the future direction of interest rates. Clearly, you have more courage, but we’d bet that this is not the first time you’ve called the end to the “multi-generational bull market” in bonds.
If we’re right, you’d have been in good company. Most economists have been calling for higher long-term interest rates since 1999.
Start here.
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