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

James A. Klotz is the President of FMSbonds, Inc. Email the Author06/03/2001