As we embark on a new year, we’re hearing the same old song from Wall Street economists and the financial media.
Now, just as they have been since the summer of 2001, these “experts” are predicting higher interest rates. They are advising income investors to either buy short-term bonds (and sacrifice income) or park investment dollars in the money market and wait for higher long-term yields.
Unfortunately, the only thing investors have learned from past prognostications is to encourage their children and grandchildren of college age to become economists, where they can be wrong most of the time and still command a seven-figure salary.
At the outset of 2004, the yields on the 10- and 30-year Treasury bond were 4.23% and 4.97% respectively, levels considered much too low by economists based on their assumptions for economic growth and inflation.
Accordingly, investment advisors and TV pundits were almost unanimous in their predictions that the 10-year Treasury bond yield would close 2004 well above 5%, based on the assumption that the Federal Reserve would likely initiate a “tightening policy” over the course of the year.
Change in Fed policy
Giving credit where it is due, the Fed watchers were correct about the change in Fed policy. The Central Bank began raising short-term rates (Fed Funds) in June and continued to boost this overnight target rate five times by year’s end, lifting it from 1% to 2.25%.
The market gurus would have been wise to stop there. Instead, they coined the phrase “rising interest rate environment,” which seems to have become a permanent element in all subsequent investment discussions.
Although we agree about the rising interest rate environment, we feel it is a disservice to investors when there is no distinction made between short-term and long-term interest rates. To newcomers in the bond market, this omission can be terribly misleading and costly. There is much lip service paid to credit risk, but precious little conversation about income risk, which investors who followed their “cash is king” financial advisors are suffering from today.
When the Fed began raising rates in June, the 30-year Treasury bond yield was 5.47%. As short-term rates continued to rise, long-term yields actually declined and closed the year at 4.83%.
The Bond Buyer Indices, which track municipal bond yields, also declined, but not by nearly as much as long-term Treasuries.
Munis are still cheap
In fact, AAA-rated, tax-free bonds yielding 4.80% can still be purchased today, which is equivalent to a return of 7.40% on a comparable taxable bond for an investor in the maximum tax bracket, and equivalent to 6.70% for an investor in the 28% tax bracket. These tax-free bond yields also compare very favorably to the after-tax yield of investment-grade corporate bonds.
It’s a new year, but our advice to income investors remains the same: Take a longer view. Buy bonds when your investment dollars are available. Don’t try to outguess or “time” the market. Satisfy your credit quality requirements first, then maximize income on every purchase.
Remember that over the life of your long-term bonds, they will sometimes be worth less than you paid for them and sometimes more. It shouldn’t matter. You are buying bonds for the income, not for capital gains.
We emphasize this subject because newcomers to the municipal bond market often don’t realize how costly it can be to wait for higher interest rates.
Our veteran investors, on the other hand, are more familiar with the mathematics of money market returns vs. compounding interest at higher rates. They’re content knowing that their interest clock will continue ticking for yet another year.
Happy New Year!