BOND INVESTORS' FORUM More

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Diversify prudently

I have been advised to stay out of bonds and invest in stocks. I’ve also heard that you should have 30% in bonds to balance the market highs and lows and keep some money in a money-market fund for stock purchases and personal emergencies. What do investors who reap a good rate of return on their investments do?
S.H.
01/28/04

Mr. Klotz responds: We are surprised that any financial advisor would recommend allocating 100% of your assets to equities. Can the lessons of the recent past be so easily forgotten?

If there was one thing to be learned from the devastation in the equity markets in the first three years of this decade, it is that the fundamental rules of investing should never be ignored.

A properly constructed investment portfolio should have an allocation of stocks and bonds (we have no quarrel with a 30% bond allocation). Stocks are an excellent vehicle for growth while bonds provide balance and cash flow. We think the financial media does a disservice to investors by discussing stocks and bonds as an either/or equation.

The investing public would be better served by illustrating how these investments complement each other in a well-designed portfolio.

Duration matters

What is your opinion on the advisability of shortening the duration of a municipal bond portfolio in anticipation of rising interest rates? Many of the long bonds currently held have unrealized gains. The rationale advanced for selling long bonds and reinvesting in bonds with shorter maturities is that it would capture gains that would disappear with rising interest rates, and that a portfolio with shorter durations will perform better in a rising rate environment.
K.G.
01/28/04

Mr. Klotz responds: For an individual investor, shortening municipal bond maturities in anticipation of higher rates is rife with pitfalls.

If you review our Bond Forum, you will see that you are not the first to have this thought. Many economists and market pundits have been predicting higher interest rates for the last three years, which would have made this strategy a disaster if employed over this period.

We believe individuals should take a long-term approach to municipal bonds by buying high quality bonds and maximizing income on each purchase. I encourage you to review the commentaries and strategies on our site that deal with laddering and the cost of waiting.

Premium value

Thank you for the e-mails about muni bond offerings. I’m always watching for high coupon rates. Since I am new at buying bonds, perhaps you could answer a question that I am currently facing: I recently bought my first taxable corporate bond at a premium price, 114 maturing in 2027. When I put my taxable interest on fed schedule B, can I deduct part of that 14 from the interest earned? How do I calculate it? Is there an equivalent deduction for tax-exempts purchased at a premium?
J.D., California
01/28/04

Mr. Klotz responds: We agree that premium bonds, when correctly priced, provide the best values in the bond market.

The IRS does not allow capital loss treatment for the premium paid since it is understood that the bonds will mature at 100 and the declining value of the premium is inherent in the purchase. If you were to sell these bonds prior to maturity, your tax preparer would determine capital gains or losses based on straight line amortization of the premium.

Getting ready to retire

I intend to retire in one to three years and will have about $1.7 million to invest in muni bonds. I have read your “Cost of Waiting” articles but I am wondering if it would make sense to temporarily buy some high quality preferred stocks that yield about 6% after taxes, paying the reduced 15% tax on dividends while I am still working, while at the same time keeping an eye on the long-term AAA muni bonds and switch to them when they start paying more like 6%, rather than the 4.75% or so they currently yield. What do you think of this approach of temporarily holding preferreds before committing a large dollar amount to munis for retirement income?
A.L., Georgia
01/22/04

Mr. Klotz responds: In theory, your thoughts make sense, but actually applying them will likely be a problem. You will be hard pressed to find high quality preferred stocks yielding 6% "after taxes." You will also be surprised how few preferreds are eligible for the reduced 15% tax cap (ask your broker to document that his recommendations are eligible).

You will also find that most preferred stocks, although callable in five years, have final maturity dates of 15 to 20 years or longer. This makes them subject to the interest rate market volatility you are attempting to avoid in the bond market.

For example, last week Boeing Co. issued preferred stock. It paid 6% with a final maturity date of 2/15/38. The issue is rated A3 by Moody’s and A by Standard and Poor’s. The stock is not eligible for the reduced 15% tax treatment and has a 34-year final maturity date. If muni rates were to rise to 6%, you would have a commensurate market value loss in these preferred securities.

It is also curious that you intend to hold taxable securities until you retire and then switch to tax-free bonds when you will presumably be in a lower tax bracket. Most individual investors employ the opposite strategy.

Having sold his businesses, investor looks to bonds

I enjoy the FMSbonds Web site. I am a commonsense investor, having operated and reinvested in my own businesses for 25 years. The businesses are sold and I anticipate investing in munis. I have not completed a tax-free exchange because it seems that the commercial real estate market is very high -- New York prices with thrift store rents! Most properties I researched do not produce much more than 5% after taxes, with a part-time job. Therefore, I believe bonds may serve me well, even after paying the 15% capital gains tax.

I am a new bond investor requiring income from the principal. What strategy or directions do you suggest? If necessary, please list the points of concern that I must address in order to accomplish my objectives.

I admit that low interest rates and premium costs in bonds concern me for the short term. In addition, the weak long-term rates are not any more exciting, even at par. Laddering was my first thought – mixing in agency step-ups – until I read your articles.
C.K., New Jersey
01/15/04

Mr. Klotz responds: In our 30 years of experience, we have found that the most successful municipal bond investors are those who focus on quality first and then attempt to maximize their tax-free cash flow on each purchase.

This entails purchasing longer-term bonds (25-30 years) when investment funds are available, rather than trying to "time" the market and interest rate cycles.

Although, as you mention, certain interest rates are low, tax-free bond rates are not, when compared to taxable bonds or historical municipal bond rates.

A tax-free bond return of 5% can be the equivalent of 7.69% to an investor in the 35% tax bracket.

Laddering sacrifices too much income for the wrong reasons.

I encourage you to review some of the questions and responses to similar inquiries in our Bond Forum and recent commentaries.

Deflation and interest rates

Don't you believe that this country is in a serious state of deflation, and that economists don't really know how to handle it? Our country is in huge financial debt. Common sense tells me money will be needed all over the place and interest rates will begin to rise sooner rather than later. Is that what you are saying, or are you saying that you don't see interest rates going higher for another year or so?
L.W., Florida
01/15/04

Mr. Klotz responds: We also think there is still a degree of deflation in the U.S. economy. Just as inflation normally leads to higher interest rates, deflationary periods are usually characterized by lower rates, as we have experienced over the past few years. We think these deflationary forces are likely to keep interest rates lower than most experts anticipate.

Simple truths on timing and waiting

I've just finished reading the Bond Forum discussion on the cost of waiting issue. What amazes me is that there appears to be this overwhelming fixation on the potential paper loss of principal when rates eventually rise. Municipal bond investing, at least from my perspective, has been driven by two main forces: One, protection and safety of principal, and two, a defined income stream to meet certain predetermined objectives. I really don't need to read my monthly statement to see if the paper portfolio went up or down. I keep enough in cash reserves (in the form of seven-day insured muni floaters with put features) for emergency purposes. Once rates hit certain levels of return that meet your objectives, you buy the paper. Forget about trying to time the market. Remember that you don't buy munis to get rich, you buy munis to stay rich.
R.M., Michigan
01/09/04

Mr. Klotz responds: We couldn't have said it any better.

What a ladder does to income

I have just read your letter on the destructive influence of laddering and am confused. Say I were to buy $100,000 of AA rated Carson City, NV Hosp Rev. bonds maturing in 2014, with a coupon of 4.2% and current yield of 4.15%. I certainly do not know what yields will do in the next year, but given their current 40-year low, it seems reasonable that yields will go up in the next few years. If so, the market value of the bonds will go down somewhat, say, to $95,000, depending on prevalent yields. If I were to buy much longer-term maturities, say 20 years at 4.75%, the value of the bonds will presumably drop further, say to $90,000, and the further out the maturity, the further the reduction in market value of the bonds.

By laddering, it seems to me that going forward from 2003, income will be reduced but the risk of reduced bond market value in an increasing yield climate will also be reduced. If I took a timeline at 2008, isn't it possible that the total of income and market value of the bonds would actually be higher with a laddered portfolio than if I settled for the higher yield longer-term bonds? I recognize that at maturity, the longer-term bond would be a better investment, but it’s those in-between years that scare me. I barely survived the recent equity slump and would sure hate to go into a fixed income slump. I would appreciate your thoughts.
H.O.
01/09/04

Mr. Klotz responds: Your observations are accurate. There is no question that longer-term bonds, while producing more income, are also more volatile. Here are some thoughts for your consideration.

The Carson City bonds that you cite in your e-mail have a 10-year plus maturity, which means they would be the longest bonds in a traditional laddered portfolio (the standard ladder is usually equally weighted with bonds due in 2, 4, 6, 8 and 10 years). The average yield on this type of portfolio would be between 2.50% and 3.00%.

Compare this item to the Carson City bonds on our Web site, which mature 9/1/09 and yield 2.90%. This would approximate the average maturity and yield of a laddered portfolio (5 years and 9 months). Bonds from the same Carson City issue due in 2029 yield 4.98% to maturity. Many financial advisors would recommend "sacrificing 2.08%" for the market stability of shorter bonds. What they are misunderstanding is that the difference in annual income is actually over 70%! Let’s do the arithmetic.

We will assume an investment of $100,000. The income on the shorter Carson City bonds is $2,900 per year. The income on the longer bonds is $4,980 per year. The difference in annual income is $2,080.

As you can see, the longer bond returns 71.7% more income annually. This is more of a sacrifice than most bond investors are willing to make. They buy municipal bonds for the income, not for capital gains. They utilize long-term funds and are not focused on market value. They are comfortable with the fact that these long-term bonds at times will be worth less than they paid for them. In the meantime, they provide themselves with 50% to 70% more reinvestable income to take advantage of the higher interest rates if they materialize. They invest their money when available and avoid the prohibitive "cost of waiting."

We must also point out that municipal bond rates, as opposed to Treasury bond yields, are nowhere near 40-year lows.

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