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I have a large portfolio of California municipal bonds with an average yield of about 5.20% and eight to nine years in duration. In the current interest rate environment, what maturity dates and quality would you recommend for additional purchases? I would like to obtain yields of close to 5.00%, but I’m concerned about buying long maturity issues if interest rates rise. Also, you talk about “longer-term” bonds. Are you referring to 30-year bonds only or 20 to 30, etc.?- L.C., California
Having visited our Web site, you may be aware we are proponents of buying high quality, longer-term bonds, which enables you to maximize tax-free income in your bond portfolio.
This additional income can often exceed the annual income of short-term bonds by more than 60% and enables you to reinvest at higher rates if they do become available.
This philosophy has successfully served municipal bond investors over the years. They recognize that neither they nor market "gurus" have the ability to accurately predict the direction of interest rates for any length of time. In fact, most "experts" have been calling for higher interest rates for years.
Keep in mind that you are buying tax-free bonds for the income. Sometimes over the life of these bonds they will be worth more than you paid for them, and sometimes less. Neither condition should prompt a sale. Bonds are purchased for income, not capital gains.
Today, for a California resident, the return on 5.00% in-state bonds can be comparable to earning 10% on taxable bonds for investors in higher tax brackets.
Regardless of any fluctuations in market value, the dependable stream of tax-free income provided by high quality municipal bonds can be counted on year after year. That's why you are buying bonds in the first place.
As to what we consider to be “longer-term” bonds, it depends on the yield curve at the time of the investment. Whenever we can capture 75% or more of the 30-year rate with a 20-year bond, we would opt for the shorter maturity.
I'm a long-term individual bond investor with a goal of getting a minimum of 5%. California bonds are selling at a very high premium right now. I'm sitting on some cash and wondering what next year might bring in terms of rates and prices.- E.G., California
In the 40 years we've been involved in the fixed-income markets, we have yet to see anyone accurately predict the direction of interest rates for any period of time. In fact, the majority of economists and so-called experts have been forecasting higher interest rates every year for the last decade.
The most successful tax-free bond investors commit investable dollars to the market when available, rather than parking these funds in money-market instruments or CDs in an attempt to time the market.
The longer your money is left in these types of accounts, the more money you’ll forgo waiting for interest rates to rise – a phenomenon we refer to as the cost of waiting. If rates do move up, you will need to earn more than 5.00% to achieve your 5.00% goal, and if they don't, you will never catch up.
Bond yields cannot be evaluated in a vacuum; they must be compared with other income options.
In today’s market, no taxable fixed-income bonds (corporates, Treasuries, or agency securities) provide the after-tax return of high quality California bonds.
I like your articles, but stocking up on long-term bonds and paying par plus a premium to get maybe 5% yield with investment grade ratings is setting yourself up for a big loss of principal when interest rates increase, and they certainly will at some point over the next 20 years. You also assume that the issuer will remain solvent over the entire 20 years. I'm a fixed-income guy, but it's tough these days to rationalize all these variables and go out 20 years or more.- J.G., Florida
It’s a funny thing: To us, “these days” don't seem to be significantly different from the old days. Although you have valid considerations, they would have been equally reasonable 10 and 20 years ago.
As you know, an investment contains elements of risk, so it can't be analyzed in a vacuum. It must be evaluated within the context of possible alternatives.
In our article, “Avoiding Interest Rate Roulette,” we attempted to illustrate that for income investors, the yield on CDs and short-term bonds are not attractive options, while 5.00% tax-free yields that can be equivalent to 8.50% or more on taxable investments are extremely compelling.
Over the life of your bonds, they will sometimes be worth more than you paid for them and sometimes less, but on investment-grade munis, your tax-free interest clock keeps ticking.
This report is produced solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. This report is based on information obtained from sources believed to be reliable but no independent verification has been made, nor is its accuracy or completeness guaranteed.