A time-worn investment strategy proffered by seers trying to outguess the municipal bond market is having yet another day in the sun.
In an unpredictable market, they say, bond ladders are the right antidote.
We say it’s an almost sure-fire way to sacrifice tax-free income.
Fed affects short rates, muni investors think long
Regardless of the unfavorable results, bond ladders have been promoted for decades. Recently, once again, we’ve seen their supposed benefits touted to financial advisors.
This comes as the Federal Reserve Board has been aggressively raising short-term rates to tame inflation.
The strategy for this unpredictable rate structure, they suggest, is to build a 10-year bond ladder. That is, investors should buy bonds with various maturity dates so when they mature, proceeds can be reinvested in bonds at presumably higher rates.
What the promoters neglect to mention is that the Fed sets the shortest of interest rates – the rates banks charge each other to lend overnight.
Conversely, municipal bond investors focus on long-term rates, which are determined by the market.
Higher yields in the long run
We explored this phenomenon last summer (“Don’t Get Fooled by the Fed”) and we’ve seen the consequences unfold as expected.
The yield curve has been inverted for months. An inverted yield curve occurs when short-term yields are higher than long-term yields, and it usually presages a slower economy or recession.
Long-term muni rates (which are the highest in decades) have been edging lower, indicating the Fed is achieving its objective and the economy is cooling.
What does this mean for those with bond ladders?
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Instead of taking advantage of attractive long-term yields now, they will likely be reinvesting proceeds of their shorter-term bonds at lower yields later.
As we told Forbes years ago (“Supercharged Munis”), the performance of bond ladders over time reveals their shortcomings.
Don’t let relatively high short-term yields obscure the bigger picture. The best bet today – as it has always been – is to lock in long-term rates.
It’s an advantage that ladders, which rely on the impossible task of accurately predicting the future, can’t reach.