Few strategies involving tax-free bonds provoke as much discussion as laddering. Though a close analysis will reveal why it shortchanges investors, many still assert its virtues.

For example, an investor recently called into question an article on laddering we wrote several years ago, launching another round of discussion in the Bond Forum. Though we disagree with the investor’s conclusions, his thoughtful analysis merits a fuller discussion.

A lesson for the ages

In our previous article, we looked at the 1970s and early 1980s, an anomalous time in which long-term bond prices dropped dramatically. Six percent bonds purchased at 100.00 in the mid 1970’s were trading at 50.00 by 1980.

The money supply and inflation were out of control until Paul Volker took over at the Fed. He rightfully concluded that raising the Fed Funds rate above the rate of inflation would break the cycle of spiraling inflation and extraordinarily higher interest rates. We believe the results of this action by the Fed, and the lessons learned during this period, ushered in the low interest rate environment that we have experienced over the ensuing years.

It also taught us to go long.

Investors who paid 100.00 for the 6% bonds mentioned above sold them for approximately 50.00 and used the proceeds to purchase bonds that were similar in nature, but different enough to avoid violating the IRS “wash sale” rule. In other words, they swapped the 6% bonds of one issuer for the 5.75% or 6.25% bonds of another issuer.

An investor with $200,000 in munis could establish a $100,000 tax loss without losing his position in the market.

The investor was then able to use this loss to offset $100,000 of capital gains, which would otherwise be subject to tax. (The spiraling inflation of that period created tremendous gains in real estate, commodities, etc.)

If the investor had no gains, he could use the loss to reduce his adjusted gross income by $3,000 every year going forward for the next 33 years. Best of all, the investor’s new bonds regained all of their lost market value in the following years. Coupling the tax benefit with the 40% to 50% income advantage over the laddered portfolio convinced us that short-term ladders were not the way to go for the individual investor. Remember: the laddered portfolio only produces new money every two years, and the new bonds purchased (10-year bonds) provide nowhere near the maximum tax-free income available.

Not on the scorecard

The tremendous tax savings, which were directly attributable to owning long-term bonds, are not factored into any yield calculation, but surely enhanced the value of these bonds. This type of flexibility is not available with a 10-year ladder.

The fact is, laddering doesn’t work for municipal bonds. A more prudent approach to tax-free investing, whose wisdom has been borne out over time, is to maximize cash flow with every purchase.

Terry O'Grady is the Head Municipal Bond Trader of FMSbonds, Inc. Email the Author05/09/2007