Bernanke’s Message to Muni Investors

Klotz on Bonds

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<h3>James A. Klotz</h3>

James A. Klotz

Federal Reserve Chairman Ben Bernanke has some advice for tax-free bond investors: Go long!

Well, he didn’t say those exact words, and he’s certainly not doling out personal investment recommendations, but the implication of the Fed’s actions earlier this month are unmistakable.

In yet another round of quantitative easing (QE3), the Fed announced plans Sept. 13 to purchase $40 billion in mortgage-backed securities. More important, though, is the Fed’s pledge to extend its policy of extremely low interest rates through at least mid 2015.

It’s no secret that historically low short-term interest rates over the past four years have been no less than catastrophic for savers and fixed-income investors, who parked investment dollars in money market funds, waiting for higher interest rates. Now, from the Fed’s pronouncement, we know where they are likely to be for the foreseeable future.

The Cost of Waiting

Our years in the municipal bond market have taught us to caution investors against attempting to predict the direction of interest rates, and once again, recent history has clearly illustrated that trying to “time” fixed-income markets has been an exceedingly expensive proposition.

In 2008, many investors eschewed the opportunity to lock in 5.50% or 6% returns on high quality tax-free bonds and chose to remain in cash or short-term laddered portfolios, which provided little or no income.

They sacrificed the substantial income available, intending to reinvest at the higher rates promised by so-called experts and financial gurus who were convinced then, as they are now, that Fed policy would prove to be inflationary.

As Time Goes By

Few investors, however, knew how long they would have to wait, and fewer recognized the magnitude of the sacrifice they were making.

Consider a $100,000.00 investment made in 2008 in high-quality municipal bonds paying 5.50%.  By now, it would have produced $22,000.00 in tax-free income, whereas a tax-free money market fund would have returned virtually nothing.

Picture this: If an investor could purchase a 7% tax-free bond today, it would take 11 years, from this point forward, to make up the income provided by the 5.50% bond in our example above. (Obviously, this is hypothetical. After the Fed’s announcement, no one is expecting to buy a 7% muni anytime soon.)

The reason this subtle principle is lost on many investors can be attributed to the financial media, who discuss income investing in the same frame of reference as the equity markets, “buy low, sell high.”

This incongruity prompted us to begin writing a series of articles, “The Cost of Waiting,” which was later featured in Forbes Investment Guide’s “Supercharged Munis.”

Now that Bernanke has assured us that the cost of waiting will continue its inexorable onslaught, reluctant income investors should consider longer-term high quality tax-free bonds.

In this lower-return investment environment – the “new normal” – a 3.75% tax-free bond (comparable to 6.15% on a taxable bond for an investor in the top tax bracket) is extremely attractive when compared with other fixed-income investments.

Under most circumstances, investors can’t count on the Fed for sagely personal investment advice. In this case, though, the message is clear.

James A. Klotz

President

James A. Klotz is the President of FMSbonds, Inc.
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Sep 28, 2012

Please note that all investing entails risk. Fixed income securities are subject to risks that will affect their value prior to maturity. Some of these risks can be related to changes in market conditions, issuer creditworthiness, and interest rates. This commentary is not a recommendation to buy or sell a specific security. All references to tax-free income refer to U.S. federal income tax. Income earned by certain investors may be subject to the Alternative Minimum Tax (AMT), and or taxation by state and local authorities. Please consult with your tax professional prior to investing. For more information on these topics please click on the “Bond Basics” link below or search by keyword at the top of this page.