If you’re familiar with bonds, you probably know who Bill Gross is.
Known reverently as the “Bond King,” Gross manages the Pimco Total Return Fund, the world’s largest bond fund. When Gross speaks, bond investors and fund managers listen, including our staff here at FMSbonds.
His recent comments in an Aug. 8th newsletter, however, took us by surprise. He declared that a “new bull market” in bonds had begun.
We never knew
It seems that according to market technicians, Treasury bonds have been in a bear market (cheaper prices and higher yields) since the Fed began its series of short-term interest rate hikes in June 2004. Who knew?
Once again, the financial media, focusing on these comments, provided a distorted picture to individual investors who buy bonds for income rather than trading profits.
What bear market?
One of the reasons we missed the bear is our steadfast resolve to encourage individual investors to buy longer-term bonds that promise to pay a safe, steady stream of tax-free income. We recommend they buy bonds when investment funds are available and not get caught up in the futility of trying to predict the future direction of interest rates (yields).
Those who have followed this strategy are very pleased they did since there has been no bear market in municipal bonds.
Which rates are which?
On numerous occasions, we have lamented the fact that TV pundits and the financial press have become enamored of pet phrases such as “rising interest rate environment,” while failing to distinguish between the shortest of interest rates (Fed Funds) and longer rates, which are most important to income investors.
Unfortunately, this type of misinformation has confused many individual investors, keeping them on the “sidelines” in anticipation of the promised higher rates, which have never materialized.
In fact, according to weekly muni bond indexes published by The Bond Buyer, long-term yields have actually been declining while short-term interest rates have been rising. When the Fed began its series of tightening moves in June 2004, the long-term revenue bond index yield was 5.40% and it never moved higher during the ensuing period of rising short-term rates. Last week the index fell to 4.97% and it is poised to move lower.
The income risk trap
We expressed concern in our commentary of Feb. 27, 2006, A Forward Strategy For The Inverted Yield Curve, that bond buyers would be enticed by the higher rates offered on shorter-term money market instruments and abandon their successful strategy of buying longer-term bonds. We said at the time that these investors, thinking they were reducing their “market risk,” were actually exposing themselves to “income risk,” which could prove to be even more perilous.
Beware
Once it is clear that the Fed has sufficiently slowed the economy and its tightening cycle ends, short-term rates will drop as quickly as they rose, posing a reinvestment dilemma for income investors. Unfortunately, at that point, long-term rates will likely be decidedly lower.
Today, investors can still buy investment-grade tax-free bonds yielding 4.50% to 5.00%. These returns are comparable to 6.92% and 7.69% on a taxable investment for an investor in the highest tax bracket, and 6.25% and 6.94% respectively in the 28% tax bracket.
We think this makes a great deal of sense in this low-return economic environment.
Bill Gross and his followers, who are fund managers and traders, may discuss bulls or bears, but for the average investor concerned with generating income, it’s merely a distraction. Our focus is on staying the course, keeping the interest clock ticking and maximizing income on each purchase.
