It is becoming increasingly difficult to pick up any financial publication without being confronted with the general consensus among economists and financial gurus that higher interest rates are looming just around the corner.
As we frequently state, we have never seen anyone accurately predict the future direction of interest rates for any extended period of time. We have also observed that the greater the unanimity of opinion, the less likely it is to be on the money.
Because of the difficulty in timing interest rates and the prohibitive “cost of waiting” , we have seen time and again that the most successful bond investors are those who buy bonds when their investment dollars are available, rather than trying to time the market.
Unlike equities, tax-free bonds are purchased for income, not capital gains. Sitting in the money market waiting for rates to rise has always been a fatally flawed strategy, and invariably puts an income investor in a position to be continually playing catch-up. With money market funds paying almost nothing, this strategy has recently become even more punitive.
Why munis won’t follow Treasurys
Even if rates on Treasury bonds were to rise, we do not expect tax-free bonds to follow suit.
Even without new legislation, tax brackets will rise. In 2011, tax rates will automatically revert to 2001 levels. The top rate returns to 39.6%, followed by 36%, 31%, and 28%, instead of the existing 35%, 33%, 28% and 25%. Additionally, all stock dividends will once again be taxed as ordinary income, and long-term capital gains will again be taxed at 20%, up from 15%.
These higher tax brackets and the loss of tax-advantaged dividends will create heightened demand for tax-free income. This increased demand should keep tax-free bond rates in check, even if taxable bond rates are rising.
We have seen some evidence of this already.
Since the beginning of December 2009, 30-year Treasury bond yields have risen from 4.21% to approximately 4.75% this month.
Long-term muni yields have not only resisted this trend, they have actually declined.
Supply and demand
The aging U.S. population continues to have a major impact on the demand for tax-free bonds. As an increasing number of baby boomers reach retirement age, they are turning to tax-free bonds and bond funds to satisfy their income needs.
At the end of 2009, individual investors held approximately $8 trillion in cash deposits and money market funds, earning less than 0.05%. With the promise from Ben Bernanke, Federal Reserve Chairman, to keep short-term rates low for the “foreseeable future,” a good portion of these funds will be seeking more favorable returns in the municipal bond market.
Build America Bonds reduced issuance of tax-frees
As we have discussed in a recent commentary “Popularity of BABs Bodes Well for Tax-Free Bonds”, the popularity of taxable “Build America Bonds” (BAB) has dramatically reduced the issuance of traditional tax-free munis.
Taxable bond sales comprised 21% of the municipal bond market in 2009, compared with 5% in 2008. Because the BAB federal government subsidy is extremely attractive to municipalities with funding needs, the percentage of traditional tax-free bond issuance will continue to decline.
If 2010 unfolds as we anticipate, growing demand and shrinking supply will dampen any tendency for tax-free bond yields to rise, even if Treasury bond rates move higher.
By the way, since everyone is entitled to an opinion, here’s ours:
Once again, we would not be surprised if the conventional wisdom regarding the general direction of interest rates turns out not to be wisdom at all.