Municipal Bonds FMSbonds.com: Tax-free Bond Specialists -THE MYTH BEHIND LADDERING

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THE MYTH BEHIND LADDERING

Before you decide to invest in municipal bonds, it is important to determine exactly what you are trying to accomplish.

If your priority is to maintain constant market value in anticipation of a near-term need for cash, we recommend buying very short-term bonds or certificates of deposit, insured by the FDIC. If you have a longer-term horizon and have some degree of risk tolerance, then invest in high quality, long-term bonds that maximize income and tax-free cash flow. When it comes to municipal bonds, laddering sacrifices too much income to be considered much more than a tax-free savings account.

The Long Term View

Risk is inherent in any investment. When you buy long-term bonds, we can promise that sometimes these bonds will be worth less than you paid for them, and sometimes they will be worth more. With a long-term view, it shouldn't make any difference.

Investors in the higher tax brackets buy municipal bonds because there is no other investment that can provide comparable returns with the same degree of safety. By laddering a portfolio, you will sacrifice the most attractive feature of a municipal bond portfolio: high tax-free cash flow. Today, long-term, quality tax-free bonds can be purchased with higher yields than taxable Treasury bonds.

Don't you find it curious that given all the so-called experts who recommend laddering, not one has produced a model replicating any period of time in U.S. economic history when this strategy outperformed simply buying and holding tax-free bonds?

Last week, the Triborough Bridge and Tunnel Authority issued tax-free bonds. This was a AA-rated issue and had bonds maturing from 2004 to 2032. A laddered portfolio would invest equal sums in 2, 4, 6, 8 and 10-year bonds. These bonds would produce an average return of 2.77% annually. The long-term bonds were priced to yield 4.79%.

Assuming a total investment of $500,00, the long-term bond produces income of $23,950 annually, $10,100 more than the laddered portfolio. (This represents 73% more income.) Since the income earned from a long-term portfolio will exceed the laddered portfolio by 40-100%, the laddered portfolio will never catch up.

What About a Rising Rate Environment?

The laddered portfolio, despite popular opinion, never really has an opportunity to take advantage of dramatically higher rates. Only 20% of the portfolio comes due every two years, and by replacing them with 10-year bonds (not the highest yielding bonds), it is difficult to raise the average income of the laddered portfolio.

For example: If, two years after constructing our Triborough Bridge ladder, long-term interest rates jumped to 10% a 10-year muni would likely be paying approximately 6%. As the two-year bonds mature, we will add the new 6% 10-year bond to the ladder. The average annual income rises only to 3.64%. If, two years later, these higher rates prevail and the laddered portfolio adds another 6% bond, the annual income rises to 4.38%. If these rates persisted for another two years, the laddered portfolio would still be producing less than 5% (4.99) annually.

Meanwhile, over this period, the long-term portfolio has produced additional income of $20,200 in the first two years, $11,500 during years three and four, and $4,100 of additional income between year five and six. The income difference has allowed the long-term investor to buy $35,000 additional bonds yielding 10% or an additional $3,500 in income.

After year six, the laddered portfolio is producing income of $24,950 per year, while the long-term portfolio now has 535M in principal and is producing tax-free income of $27,450.

Get the picture? Obviously, rates are not likely to jump to 10% in two years, nor stay that high for six years, since 10% long-term rates would dampen economic activity, setting the stage for lower rates.

What About Interest Rates

Although we are not in the forecasting business, we believe that as long as economists and investors are convinced that rates have nowhere to go but up, we wouldn't be surprised to see them head even lower.

Inflation, and demand for money, are the main ingredients necessary for rising rates. In our crystal ball, we don't see a hint of where either will come from.

If rates don't rise at all or actually decline, obviously the differences between these two portfolios becomes even more dramatic. (See " Cost of Waiting" strategies.)

We really can't tell you why many brokers and financial planners promote the laddering concept. Perhaps they feel it lends an impressive degree of sophistication to their presentations.

Lately, we have been encouraged by individual investors. Having witnessed the vaporization of $8 trillion in the equity markets, they are beginning to rely less on "professional" advice and more on their own common sense.

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Municipal bonds, like other fixed income instruments, are subject to changes in market price based upon factors including the level of interest rates, market conditions and credit quality of the issuer.

If you wish to sell your bonds before they reach maturity, you will
receive the market price at that time, which may be more or less than the price you originally paid. Yields will fluctuate if sold prior to maturity.