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ETMs vs. pre-refunded bonds

Most of my bonds are ETM (escrowed to maturity). I keep hearing about pre-refunded bonds. Can you please tell me the difference between bonds that are escrowed to maturity in US govs (ETM) and pre-refunded bonds? Is one safer than the other? Thanks.
B.R., Washington
8/22/03

Mr. Klotz responds: There are various ways that municipal issuers can remove debt from their balance sheet in order to borrow at lower rates. When a municipal issuer has the ability to borrow at a lower rate than their outstanding debt, they may choose to float a new bond issue for the purpose of refunding an older issue.

The proceeds of this new issue can be utilized in two different ways, which change the character of the older issue.

1. Escrowed To Maturity: In this case the proceeds of the new issue are used to buy treasury bonds, which mature at the same time as the older municipal issue. These government securities are then placed in escrow behind the old issue and pay the principal and interest on the original bond until retired on the final maturity date.

2. Pre-refunding: The issuer in this case uses the proceeds from a new issue to, once again, buy treasury bonds. This time, however, the treasuries mature on the "call date," (rather than the maturity date) and all the original bonds are retired at that time. Pre-refunded bonds are also escrowed in US treasury bonds but their final maturity is now the same as the call date on the original issue. The one caveat when buying ETMs is to be certain that all calls have been defeased or the bonds are priced to the call date. There have been cases in which issuers have tried to call bonds that were escrowed to maturity.

Ladders, interest rates and inflation

I'm not a mathematician, but I have some understanding of the math behind your advice to "buy long-term tax-free munis" versus "taking a laddering approach." Your recommended approach seems to be predicated on the assumption that current rates are not the lowest rates that will be available in the near future, and that current long-term rates are near the average long-term rate that will be seen in the next 15 to 20 years. However, if you believe that bond rates (including long-term rates) are at an all-time low and are going to go up within the next two to five years, why would you commit all of the funds that you are going to allocate to long-term munis at relatively low rates? Why not have a short-term duration and then, when rates do go up, invest in long-term bonds at higher rates?

I am a buy-and-hold-to-maturity bond investor. I currently have about $2 million in CA muni bonds with a duration of about seven years. I have an investment in real estate that is going to mature in about three months that will result in about $1.5 million becoming available to invest. My plan was to invest most of the additional $1.5 million in CA munis and lower the duration to about five years because I strongly believe that high inflation (10% or greater) will come about in the next two to five years and will continue for at least another five years.

I agree that market timing is fraught with danger. I also agree that bond rates do go up and down. But if I was to now commit all of my funds to a 15- or 20-year duration at 6% and in the next few years inflation goes to 12%, I will either have a major tax write-off if I
sell and repurchase or, if I hold to maturity, my interest income will not keep up with inflation.

If you believe that (1) the Fed's systematic devaluation of the dollar will continue and (2) that a high rate of inflation will soon (two to five years) follow, and (3) that long-term bond rates currently do not adequately hedge against that eventuality, it seems that some degree of
laddering is better than committing all of your funds to long-term munis at the current relatively low rates. That way, when rates do go up, you will have funds available to invest in long-term munis at appreciably higher rates than are currently being offered.

Do you disagree with this?
J.C., California
8/15/03

Mr. Klotz responds: Thank you for your thoughts. Your ideas seem to be well thought out, but it is difficult to agree with some of your assumptions, particularly regarding future inflation. It is hard for us to conceive of 10%-plus rates of inflation for any extended period of time. This would be unprecedented in US history. Even one or two years of double-digit inflation would likely lead to draconian measures by the Federal Reserve, like those orchestrated by Paul Volcker in 1982.

Our opinion of laddering is not based on interest rate assumptions, since we would be the first to admit our inability to predict the future, but rather from our experience in this market for 33 years.

We don't know over what period of time you accumulated your current bond portfolio, but we will guess that with a duration of seven years, you probably sacrificed 50% or more of the tax-free income available on the long end of the market when you made your purchases. Today, AAA insured California bonds would yield approximately 3.30% in seven years and about 5% on 30-year bonds (a 51% difference in interest income).

In a $2 million bond portfolio, this would amount to an income difference of approximately $34,000 per year. This can be a hefty price to pay to maintain a constant market value on bonds you are not likely to sell under any circumstances.

Considering your thoughts on inflation, I am curious as to why you would convert a real estate investment to a bond investment. Real estate can be an ideal hedge for a long-term bond portfolio, producing gains to offset bond losses if or when inflation accelerates dramatically. By executing the type of "tax trade" you described in your e-mail, these gains could potentially be taken tax-free. This can't be done with short-term bonds.

If we were anticipating the type of interest rate environment that you foresee, we would be more inclined to a "barbell" structure than a laddered approach. This would enable you to produce higher reinvestable cash flow but keep some powder dry for the higher interest rates you anticipate (but can't time) down the road.

Call features are important

I am interested in Federal Housing Mortgage bonds that are 10-year bonds paying 6%. They are long-term bonds, callable in three to five years and have an AAA rating. I am in the 28% tax bracket. I've never had these types of bonds before. I have $100,000 to invest, so it's got to be the right investment. I also have other securities. I thought about 50 in munis and 50 in housing. I know it sounds like I have no faith in my broker. He's a fine young man who is a CPA and has performed very well for me. But with the economy like it is now, and with that kind of money, I thought I would ask a second opinion.
K.B.
8/01/03

Mr. Klotz responds: Ten-year "AAA" rated Federal Home Loan Bank "bonds," which cannot be called for three years and are selling at 100, are an excellent value. Caution: Make sure they are bonds, not mortgage backed securities, or there is no call protection if rates drop. Find out the first date they can be called. It is either three years or five years, not three to five years.

What specialists know

Your articles on laddering make a lot of sense to me. But when purchasing tax-free bonds, why would I invest with an unknown online firm vs. using a company like Schwab or Prudential? Are your prices lower?
Dr. C.A.
7/29/03

Mr. Klotz responds: Thank you, we're glad you find our information useful. Our clients tell us that when they purchase bonds, it makes sense to go to a firm that specializes in bonds. And for more than 25 years, that's all we've done. The commentary, strategies and analyses you read and use are all original and written by tax-free bond specialists. Our bond offerings may be purchased directly online (a first in the industry) or you may speak to a bond specialist by phone or visit us in person. But you'd expect those things from experts in a particular field - and not from those that only "discovered" bonds when the stock market turned down. (For Schwab's position on bonds, see: "Investors Need Help, Not Hype"). I think when you compare the level of experience and the bond values we offer, it will be an easy decision for you - just as it has been for thousands of investors from across the country since 1978.

More on ladders

You must get really tired of hearing about laddering! You have all the math and reality on your side of the discussion, yet some do not understand. I love numbers and can vouch for your position. I also have been buying the longest (highest return) bonds I can find for 19 years now (some continue growing at 11%!). All the best, thanks for the great articles.
R.H., Kansas
7/26/03

Mr. Klotz responds: Thank you for your kind words.

Laddering (cont'd)

I'm an investor in the top tax bracket and I have been investigating municipals in more detail. I retained financial planners to help with an asset allocation strategy. Part of their recommended allocation includes a bond ladder. I read your strategy article on "why laddering leaves you on the bottom rung" and forwarded it to the planners. They say the price volatility of a long bond doesn't coincide with their objective of capital preservation. I would be interested in your response. Thank you.
B.I.
5/20/03

Mr. Klotz responds: The most successful bond investors are those who invest for the long term. They are not traders. They are aware of the cyclical nature of interest rates, but they're not concerned with maintaining constant market value. They recognize that over the life of a long-term bond, it will sometimes be worth more than they paid for it and sometimes less. It doesn't matter to long-term investors because their tax-free bond portfolio remains fully invested and produces maximum cash flow. They are not going to sell their bonds either way.

Let's look closely at a how a ladder really works. Yesterday, New York City TFA issued $550 million in municipal bonds. This AA-rated issue has bonds maturing from February 2005 to 2033.

An equally weighted six-year ladder on that issue (2005 to 2008) would result in an average yield of 2.31%. The yield on the long-term bond due in 2033 is 4.92%. Every $100,000 invested in the long-term bond would produce $4,920, while the laddered portfolio produces $2,310 - a difference of $2,610 or 112% more annual reinvestable income. The laddered portfolio may or may not be keeping pace with inflation, depending on which inflation measure is used.

The major downfall in the laddering approach is that, even if rates are higher by 100 basis points over the entire yield curve, when the first laddered bonds come due, the 6- to 10-year maturities will still not reach the 4.92% being paid by the original bonds purchased in the long-term portfolio.

Yes, the original long-term bonds purchased will now be valued at approximately $87,000. Since our clients hold other assets besides bonds, there would likely be a gain in another area of their investment portfolio. At this point, we would sell the original bonds and replace them with a similar bond at approximately the same price, thereby establishing a tax loss, which allows the client to take a tax-free capital gain elsewhere.

Eventually, rates decline, as they always do and their long-term bonds will return to full value. Disregarding all theoretical arguments, our clients appreciate the common sense of the long-term bond approach because they don't need to sell their bonds to buy groceries.

The math behind laddering

I have significant assets to invest and have been looking to commit more funds to muni bonds. My stockbroker recommends a laddered portfolio. He says rates will eventually rise, which means the market value of long-term fixed income investments will drop - a scenario he calls "ugly" for investors. I am curious as to your feedback.
B.D., New York
5/20/03

Mr. Klotz responds: It is important to make the distinction between fixed income markets and strategies for individuals as opposed to institutional investors. If we were advising bond fund managers or institutional investors, we would employ a laddering strategy because institutions must mark their holdings to market and bond funds market their shares based on annual total return.

However, individual investors don't have these constraints, which allows them to take advantage of the steepness of the municipal yield curve and maximize their tax-free income on each purchase. Ironically, your stockbroker's concern about losing the ability to reinvest at prevailing market rates is the best argument against laddering.

Picture this: When rates rise, a laddered portfolio only has reinvestment dollars available every two years. This allows reinvestment of only 20% of the portfolio and, worse, this strategy dictates buying only the 10-year bond yield, which in a rising interest rate environment usually provides 60% to 80% less income than available in the longer maturities.

The first strategy we posted on our Web site in January 2000 was entitled "Laddering Leaves You on the Bottom Rung". In this article, we show the actual arithmetic in comparing laddered and long-term portfolios, using actual bond issue yields.

It's simple: If you want to end the debate, ask your broker to identify any 10- or 20-year period in history that a laddered municipal portfolio outperformed a long-term bond approach utilizing actual bond issues. We couldn't come close to finding one. He won't either. The same market that your broker termed "ugly" was a thing of beauty to our clients, since it allowed them to buy the highest tax-free rates in history.

Eventually, interest rates declined (as they always do) sending these long-term bonds to extraordinary premiums, while laddered bonds returned to their usual pattern of being reinvested every two years at lower rates.

If you would like an objective opinion from a municipal bond expert who does not sell bonds, we would recommend a recent commentary by Joe Mysek of Bloomberg.com on this subject.

Don't fear interest rates

I have been reading your commentaries and strategies and am learning a lot. There is one aspect of your buy-and-hold strategy I would like you to comment on. Generally, interest rates rise and fall along with inflation. When inflation rises, interest rates also rise, so that if you can stay invested with current market rates, you can keep up with inflation. The buy and hold approach does not allow you to do this. For example, if I invest in long-term bonds now, and interest rates and inflation rise sharply, I will be locked into a below-market investment, and considering inflation, I may actually be losing ground the longer I hold the investment position. Your comments please.
B.G., Massachusetts
5/16/03

Mr. Klotz responds: Your concept regarding interest rates and inflation is accurate. Inflation is the enemy of fixed-income investments and is typically the main factor leading to higher interest rates. Historically, interest rates follow a cyclical pattern because higher interest rates cause a slowdown in economic activity, which also has the effect of reducing inflation. But, as we have said before, it is very difficult to predict the timing of interest rate fluctuations.

If you are a tax-free bond investor, buying and holding long-term bonds is the best strategy for weathering inflationary periods because of the significant amount of additional interest you receive from longer-term bonds. When tax-free bond rates rise, longer-term bond yields rise more quickly than the yields on shorter bonds due to the larger "inflation premium" built into long-term securities. The additional income earned on long-term bonds enables an investor to take advantage of the higher rates available when they occur.

In periods of higher inflation and higher interest rates, the market value of your bonds may be lower than when you purchased them. But, as we have said many times, what's the difference? Long-term bond investors don't sell their bonds when they have market losses or profits. They buy bonds for income and take advantage of higher rates rather than fear them. If you try to protect yourself from "below-market interest rates" by buying short-term bonds yielding 2 or 3 percent, you are intentionally condemning yourself to this fate. I think you will find our "Cost of Waiting" strategies very helpful.

Bonds and the president's stimulus plan

I believe the tax on stock dividends will be repealed just as the tax on bank interest should be repealed. This will stimulate the economy, which certainly needs a new direction. Yes I do believe it will have an impact on the demand for munis.
S.L., California
4/21/03

Mr. Klotz responds: Thank you for your comments. It would appear that you are more optimistic than the administration regarding the likely passage of the president's tax cut proposal in its original form.

This weekend, in an interview with "The Wall Street Journal," Treasury Secretary John Snow suggested that he would settle for half the dividend repeal in the president's proposal if Congress agreed to eliminate it entirely over the rest of the decade. Mr. Snow said he would also consider delaying the reduction of the top individual tax rate from 38.6% to 35% as originally proposed. The terms of the final package, which would need congressional approval to become law, are still pretty much up in the air.

The original proposal called for $726 billion in tax cuts. The 2004 congressional budget would effectively cap the plan at $550 billion. Also in the background is the promise of the Senate Finance Committee's Charles Grassley to limit the tax givebacks to $350 billion.

Mr. Snow said the dividend tax repeal portion of the plan could be restructured to cut the dividend tax by 50% this year and then phase in the rest of the cut over the "next several years."

If there is a threat to the municipal bond market, it would be seriously diluted by a watered down version of the proposal. As we mentioned in our commentary of January 21, 2003, municipal bond investors fall into the most conservative category of investor. Bonds and stocks are different. Regardless of market conditions, bonds return investor's principal at maturity - and interest in the meantime - while equities offer no guarantees.

Wait and see what?

A newsletter I receive says the bond bubble has burst and that investors should wait for higher yields and lower prices. It says the financial strength of municipal issuers is getting weaker as the federal deficit keeps growing. Forget about the Fed stimulating the economy, it says, citing Japan's weak economy despite lower interest rates there. It says the federal government, in order to finance its ever-growing deficit, will likely be a large seller of bonds, and that a continuing large supply of US government bonds will push interest rates higher. Also, it says the dollar will continue to weaken, which in turn will lessen the amount of foreign investment in US bonds. I think I'll follow this advice for a while and wait before buying anything else. What do you think?
S.F., Connecticut

Mr. Klotz responds: I think it's premature to call an end to the bull market in Treasury bonds. The recent back up in Treasury yields has already started to reverse itself. The 5-year bond, which reached 3.08% last week, is back to 2.82% today, while the 10-year bond, which hit 4.10%, is now trading under 3.89%.

We don't think these "hot money" moves orchestrated by professional investors should be perceived as long-term trends. Our guess is that Treasury bond yields will continue to move lower in the months ahead, particularly if the war drags on longer than originally anticipated. Nevertheless, these Treasury bond gyrations bear little relationship to the municipal market. Muni yields never made the dramatic downward move that Treasury bonds experienced. High quality municipals are trading at approximately 95% of 10-year Treasuries, which is extremely high on a historical basis.

As far as "waiting for higher yields" before investing in municipal bonds: We assume this entails parking investable funds in a tax-free money market yielding less than .25%. By not saying how long it will take for this doomsday scenario to unfold and how high rates must go to make up for accepting negative real returns over the foreseeable future, your newsletter is doing you a disservice. Our bet is that if you follow this advice, you won't be renewing your subscription to this newsletter.

Your newsletter raises important question, which if fails to answer, namely: Which investment grade issuers will be seeking comfort in bankruptcy? How high will long-term muni rates go? How long will it take for yields to reach their highs? What will trigger a buy signal? Since the newsletter draws parallels between the US and Japan, what are long-term Japanese bonds yielding?

We don't quarrel with some of the issues confronting the US economy. Identifying potential problems is easy. But we think the "cash is king" strategy, in which all investment dollars will be eroding at approximately 1.7% to 2.3% per year (depending on which inflation gauge is used), is unwise for the intelligent investor employing a long-term financial strategy.

Go long

I am close to retirement and am planning to reduce my stock holdings and increase bonds to reduce risk. You recommend against laddering bonds and instead favor buying the best long-term bonds available. Since I expect interest rates to return to higher levels somewhere down the road, I'm afraid I will get locked into a low yield if I make a major investment in bonds now. It seems a better approach would be to buy non-callable bonds in the three- to five-year maturity range and see what happens to interest rates. Since interest rates can't go a lot lower but have a lot of upside room, it seems this would be a better approach at this time. What do you think?
B.G., Massachusetts

Mr. Klotz responds: If you buy high quality bonds maturing in three to five years, your returns will average approximately 2.05%, or $2,050 in income per $100,000. However, you can still purchase AAA, long-term bonds paying 5.00%, which represents a whopping 140% more income ($5,000 vs. $2,050 per $100,000).

If you cannot tolerate any temporary loss in market value, you should opt for the shorter maturities. But keep in mind that you will have even more difficult decisions down the road. If rates rise, will you sell your five-year bonds to buy longer maturities? How will you know the right time to make this move? Interest rate forecasting can be a treacherous pursuit. How many "experts" predicted rates would be as low as they are today?

Successful long-term bond buyers are unconcerned with market value. They expect that over the life of their bonds, they will sometimes be worth more than they paid for them and sometimes less. They know they will be able to take advantage of higher rates with the additional income their bonds produce. This eliminates the guesswork involved in market timing.

I must also point out that although Treasury bond yields are near historical lows, long-term municipal rates are not. The muni yield curve is also much steeper than in the Treasury market. This provides more incentive for tax-free bond buyers to buy longer maturities. If legendary investors like Warren Buffett are correct, earning 5%, after tax, year-over-year for the next decade will prove to be a very attractive investment.

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