HOW WAITING RAISES INCOME RISK
Mention risk to tax-free bond investors and most think of credit
risk or market risk. But few consider another kind of risk "income
risk" which befalls investors who think they can outguess the market.
Many investors who bought quality, tax-free bonds last year yielding
6.00% to 6.50% are balking at today's yields, which have settled
in the range of 5.25% to 5.50%. As they wait for long-term interest
rates to rise, they are moving investment dollars, normally earmarked
for bonds, into money market funds. By doing so, they are unwittingly
subjecting themselves to income risk.
Here's why.
The Cost of Waiting
Consider two hypothetical investors. Both are in the new 35.5%
tax bracket and both have $100,000 they want to invest in tax-free
bonds.
Investor A has always believed in investing his funds as soon as
they become available. He adopted this strategy years ago, after
realizing that neither he nor his financial advisors have ever successfully
predicted the future direction of interest rates for any sustained
period of time. He simply calls his broker and buys $100,000 of
insured bonds yielding 5.60%.
Investor B is too smart for this simple strategy. He is not willing
to settle for 5.60%. He is convinced that rates will soon rise and
will wait until he can buy 6.00% bonds. He'll retreat to his tax-free
money market fund where he will earn 2.25% while he is waiting.
Believe it or not, if Investor B only has to wait six months to
get 6.00% bonds, it will still take 4.2 years to catch up to Investor
A. After four years, Investor A's 5.60% bonds will have earned $22,400.
Investor B, with six months of money market interest at 2.25% plus
6.00% for 3+ years, will have collected only $22,125.
If Investor B has to wait 18 months for 6.00% bonds, it will take
more than 12+ years to catch up with Investor A. Two years in the
money market would require 17 years at 6.00% to equal Investor A's
return.
Don't Be Fooled
The main reason investors get fooled is they don’t readily see
that the difference between 2.25% and 5.60% is not 3.35%, as it
appears at first glance. 5.60% is actually a whopping 149% more.
By waiting for higher long-term rates, Investor B really leaves
himself behind the eight ball. In the hypothetical scenarios we
presented, Investor B's prediction of higher rates was correct.
But what if he was wrong? He would never catch up!
For 22 years, I have heard many people say, I'm waiting for higher
rates. It has rarely worked to their advantage.
The most successful fixed income investors have been those who
commit their funds when available, rather than trying to outguess
the market. Beware the cost of waiting.
Remember, tax-free bonds are still selling at bargain prices when
compared to taxable fixed income investments. 7/3/01
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