Municipal Bond Forum
No free lunch
Q
I disagree with your points concerning the drawbacks of ladders. You’re not accounting for credit risk, for which you’re not well compensated for going out longer. In a ladder structure, being able to keep buying 10-year bonds is, in effect, a free lunch. The ladder gives you more access to your cash to meet cash-flow needs. Long bonds are callable and are not efficient investments, and they can be called at the worst time for the investor. Going long term only works in combination with a mostly equity portfolio, say, 70 percent or more.
A
James A. Klotz responds:
Regarding your point on more credit risk, it is our experience that when a longer-term bond defaults, so also do the shorter bonds from the same issuer.
We also can’t agree with your thoughts on inflation. Inflation does not pick and choose its targets. If the purchasing power of the dollar is eroding, you are still better off having more cash flow available for reinvestment. You may be overlooking the fact that you are reinvesting principal while our clients are reinvesting 100% to 300% additional interest on a current basis, not every two years.
The fact that bonds are callable in 10 years strengthens the argument for buying longer bonds.
The example used in our commentary was based on the Thompson Municipal Market Data Curve. As we said in our article, the 10-year bond yield on a AAA bond in today’s market is approximately 2.93% while 30-year bonds yield 4.68%. This is not 50 basis points more, as you say, but 175 basis points more. That represents 60% more income. Contrary to your figures (the source of which was unnamed) this difference in yield, in our book, is clearly worthwhile compensation for extending maturities.
Your theory on called bonds defies common sense. The maximum yield on your 10-year bond if held to maturity will always be 2.93%. If the long-term bond is called the yield will at least be 4.68% or even higher if called at a premium.
As far as your ability to have more access to your cash, you’re obviously referring to your principal. We have always been proponents of creating maximum cash flow through higher interest payments to avoid the necessity of tapping into one’s principal, which is anathema to the goals of our clients.
We must also point out that we have never suggested that an investor should maintain all his/her investment funds in municipal bonds. Asset allocation is not our area of expertise. We earn our stripes by guiding municipal bond investors in maximizing the performance of their portfolios.
If you review these numbers with an open mind, you will find, as in all other things, there is no free lunch.
Start here.
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