“Interest rates have nowhere to go but up.” “Muni bond portfolios need to be laddered.” “Investors need a professional to actively manage their muni portfolio.”
You have heard these pearls of wisdom before. They’re hard to miss. The Web is rife with investing gurus touting the supposed advantages of laddering bonds and it’s virtually impossible to avoid hearing pundits proclaim the future direction of interest rates.
For investors, it’s important not to confuse the ubiquity of these notions with their accuracy. If you’re looking for a safe, steady stream of tax-free income, adhering to the wisdom “du jour” can be a minefield. Fortunately, there are a few simple precepts of municipal bond investing that have withstood the test of time and guided successful investors for generations.
The folly of predicting interest rates
Predicting interest rates is a favorite pastime of the cable TV gabbers. It’s a sure-fire way to elicit sharp opinions – some of them convincing – and fill air time. Better yet, no one is ever taken to task regarding their interest rate prognostications.
The problem is, no one has ever, over any extended period of time, accurately predicted when, which direction and by how much rates will change. Worse, the cost of waiting for these forecasts to pan out is deceptively prohibitive.
How many years have we heard the cry that a sharp rise in interest rates is imminent?
A decade after high-quality munis were offered at 5.00% to 6.00%, it’s worthwhile to examine how investors who heeded those warnings fared by sitting on the sidelines, or by constructing 10-year ladders.
Few anticipated how long they would have to wait, and fewer still realized how much income they would be sacrificing. It was a costly misstep. For a closer examination of this phenomenon, visit “Time Flew, But Interest Rates Didn’t”.
Stay away from ladders
An old chestnut that pundits never seem to tire of discussing is the 10-year bond ladder. We think it is recommended by financial advisors because it sounds sophisticated: invest equal amounts of capital in municipal bonds with staggered maturities. If interest rates rise, the ladder will presumably provide protection if the value of long-term bonds erodes.
That, at least, is the theory sold in many financial how-to columns.
In reality, a short-term ladder is essentially another attempt to predict the movement of interest rates. It requires investors to give up an extraordinary amount of tax-free income for the opportunity to reinvest principal every two years, despite being subject to the vagaries of the market.
The common sense and time-tested alternative – a plan that is simpler and more profitable – is this: think quality first and maximize income on every purchase. Investors will earn significantly more income and can reinvest the additional income on a current basis.
The best bond manager
We often hear, mostly in sales literature, “Investors need a professional to actively manage their bond portfolio.” After 40 years in the business, we still ask why? We have never seen an actively managed portfolio outperform the individual bonds themselves, especially after costs and fees are taken into consideration.
Successful bond investors employ a buy-and-hold strategy and they pay no one for the privilege.
Consider a “professional” who charges 50 to 80 basis points to manage a portfolio. It may not sound like much, but it becomes substantial on a security that today may return 4.50% to 5.00%. In fact, a fee of 80 basis points represents 16% of the income on a 5.00% bond – and that doesn’t include additional, hidden transactional costs in a managed portfolio that don’t appear on monthly statements.
Unfounded credit concerns
It’s been almost a year since a banking analyst famous for predicting Citigroup’s woes in 2008 ventured an opinion on the muni market. And what has happened since her prophesy of a muni meltdown was broadcast on “60 Minutes”?
Prior to that now-infamous interview in which she predicted a raft of municipal defaults, states and local governments began facing the consequences of a severe economic downturn and fiscal challenges that percolated for decades. Though still facing challenges, they have since wielded a considerable array of tools to manage their shortfalls.
The result has been, for the muni market, more of the same. Defaults continue to be extremely rare. The vast majority of public finance ratings have remained stable. States have actually seen a sustained period of increased revenues – and lower borrowing costs – for the first time in 15 years.
Recently, Standard and Poor’s announced that municipal bond defaults are down by 69% so far in 2011 from the same point in 2010 – a far cry from a meltdown.
Once again, the hyperbole that garnered so much attention has turned out to be fiction.
Avoid the angles
In an age when information is spread quickly and easily, it’s often difficult to discern age-old truths from half-baked opinions.
High-quality municipal bonds are designed to be bought and held, maximizing tax-free income on every purchase. After all, that’s why income securities are purchased in the first place.
It’s a simple strategy that avoids the perils of trying to outguess the market, but probably won’t be heard on the financial channels because it’s short on pizzazz . . . but it will help you sleep at night.