Current economic weakness combined with “Enronitis” is making it difficult for investment professionals, who normally concentrate on stocks, to remain within their field of expertise.
The good news is that the financial media and the giant brokerage firms have rediscovered the tax-free bond market. The bad news is that this renewed interest has brought with it a new level of confusion and misinformation.
For example, we recently ran across an article titled “How to Ladder Your Bond Portfolio.” We’ve seen similar articles over the years and were surprised to find anyone who still recommends “laddering” a tax-free bond portfolio.
A Worn-Out Strategy
The author calls laddering a “time-worn” strategy. In fact, we think it’s a worn-out strategy that over the past 20 years has proven to be very costly to tax-free bond investors who have bought into it. In defense of the author, the source of his article was a senior fixed-income strategist at a big brokerage firm.
Another large wirehouse also made a contribution to the laddering myth in a full-page advertisement in the Money & Business section of Sunday’s New York Times. The ad said, “We’ll help you choose a mix of securities and ladder their maturities to seek a steady stream of income.”
Aldous Huxley said, “Facts do not cease to exist because they are ignored.” Laddering, despite what many say, simply doesn’t work, and we don’t know anyone who can prove, based on past performance that it does.
So why do so many financial professionals advocate laddering? We’re not sure. Perhaps they want to imply that it takes a greater degree of sophistication to build a tax-free bond portfolio than it actually does. Or perhaps they haven’t taken the time to examine the strategy they are recommending.
Look at the Numbers
Tax-free bonds are pretty simple, and a little common sense goes a long way.
The typical laddered portfolio spreads investment dollars equally in bonds maturing in 2-year, 4-year, 6-year, 8-year and 10-year maturities.
In a typical FMS portfolio, we attempt to maximize tax-free income on every purchase after first being satisfied with the credit quality. This, naturally, entails buying long-term bonds.
The laddered portfolio will throw off an average return of approximately 3.25%. Long-term insured AA-rated bonds can be purchased today to yield 5.25%.
At first glance, it appears that the laddered portfolio is sacrificing only 2 percentage points, which seems like an insignificant price to pay for reduced market volatility in the shorter maturities. But the difference is actually much greater.
For example, assume a portfolio of $1 million. The laddered portfolio will produce $32,500 in income. The longer-term bonds will pay out $52,500.
The difference between $52,500 and $32,500 is obviously more than 2 percentage points. The longer bonds actually produce 67% more income.
Tax-free cash flow is the key to maximizing return in a tax-free bond portfolio. Experienced investors know that over the life of their bonds, their bonds will sometimes be worth more than they paid for them and sometimes less. What’s the difference? There is no reason to sell your bonds in either case.
The proponents of laddering suggest utilizing this strategy on a continual basis. This means that all monies earmarked for bonds are also fully invested at all times, as is the long-term portfolio.
It should be obvious that if you are receiving 50-60% more income on every bond purchase, there will be an enormous difference in your return on investment when compared to the laddered portfolio. By continually reinvesting and compounding, the long-term portfolio cash flow provides its own internal growth.
The one thing not mentioned by firms recommending laddering is that interest rates have been declining in the U.S. since 1982. This means that every time a bond is purchased in a laddered portfolio, it is yielding less than the bond it is replacing. Some strategy!
Ladders Belong in Garages
We first discussed laddering in our online column several months ago (click here to read our analysis), and, given the amount of misinformation we’re hearing now, we expect to write about it again.
We remain steadfast in our belief, proved over time, that the best strategy for tax-free bond investors is simple: Avoid laddering. Maximize tax-free income on every purchase while being mindful of credit quality. If you need a little help, talk to a tax-free bond specialist, someone whose sole focus is helping investors reach their objectives in the tax-free bond market.