There they go again.
Almost immediately after President Bush announced his economic stimulus package, the financial media began forecasting higher interest rates, the end of the bull market in Treasury bonds and the demise of the municipal bond market.
This knee-jerk reaction stems from the notion that economic stimulus will cause an across-the-board rise in interest rates, while, at the same time, the elimination of taxes on corporate dividends will motivate investors to dump their tax-free bonds and replace them with dividend paying equities.
We are certain that this analysis will be proven incorrect on both fronts.
Where is the Inflation?
Today, the conventional wisdom is that interest rates, having hit historical lows, have nowhere to go but up and the president’s proposal will only speed this process.
We don’t see it that way.
The economic recovery that has been promised by the Fed, the Bush administration and Wall Street economists is still more illusory than factual. Inflation, which is always the catalyst for rising interest rates, has actually been trending down. Rising oil and gold prices have masked the fact that the rate of increase of producer and consumer prices continues to decline when viewed on a year-over-year basis.
Where is the Recovery?
Based on recent economic reports, the economy grew only slightly in the fourth quarter, if at all.
According to a survey by Macroeconomic Advisors, the nation’s GDP expanded at a .5% annual rate in the fourth quarter, while job growth in November and December was negative. At the same time, corporations are scaling back their spending plans while lamenting the lack of pricing power for their products. Even auto sales, which perked up in December, relied on rebates and zero-rate financing for this activity. From November to December, domestic car and truck production declined more than 7%, and total U.S. industrial production has declined four out of the last five months. These factors hardly seem to form a backdrop for higher interest rates.
Where is the Stimulus?
As far as the president’s stimulus proposal raising interest rates, we simply don’t see the stimulus.
It is generally acknowledged by economists that to stimulate the economy, additional funds have to be put in the hands of people who are going to spend it. The bulk of tax savings from the president’s plan will benefit upper income Americans, who will be more inclined to save rather than spend these additional dollars.
The Brookings Institution Tax Policy Center estimates that over 40% of the benefits to senior citizens would flow to those earning $200,000 or more. Approximately 75% of the benefits would go to the elderly earning $75,000 or more. The majority with lower incomes would be virtually shut out.
Another reason that the majority of tax-free dividends will go unspent is that more than half of all these payments already avoid immediate taxation because they are held in tax-deferred retirement accounts such as 401(k) Plans, Keoghs and IRA’s.
The Municipal Bond Market
The president’s proposal calls for eliminating taxes on dividend income. Not surprisingly, those who expect this to have an adverse effect on the municipal bond market don’t understand the mentality of the bond investor.
Stocks and bonds have a decidedly different risk profile. Municipal bond buyers fall into the most conservative category of investors. Bonds protect the investor’s principal if held to maturity, while equities are inherently riskier as exemplified by recent stock action.
We do not think investors will quickly forget that approximately $7 trillion has been vaporized from their stock portfolios over the past three years. Since their peak, the FINRAAQ Composite Index has fallen 73%, the Standard & Poors’s 500 Index is down 42% and the Dow Jones Industrial Average is off 28%.
It should be noted that during this period, a number of corporations have chosen to cut or defer dividend payments. This is a foreign concept to a bond investor.
Those who want to compare municipal bonds to preferred stocks should keep in mind that over 60% of tax-free bonds are AAA rated, while the average rating on preferred stock is closer to BBB.
Investors buy municipals because of their dependable stream of tax-free income. Unlike corporate managers, a municipal issuer cannot decide to defer interest payments. It is highly unlikely that bond buyers will trade the historical dependability of the municipal bond market for preferred stocks whose value will ultimately depend on the viability of corporate profits over the long term. Just ask investors who bought preferred stocks issued by Worldcom, Enron or even General Electric.
Speaking of long term investing: Did you know that, according to this plan, if a corporation does not pay federal taxes for any reason, its dividends would not pass tax-free to investors? This would mean that an investor has no guarantee that his current tax-free dividend would retain its tax exemption.
Bonds are Already Cheap
One can also make the argument that there is no reason for municipal bond prices to fall, since they are already cheap compared to other fixed-income securities. With current yields of 30-year, AAA tax-free bonds in the 5% range, they are trading at more than 100% of the yield on 30-year Treasury bonds.
Historically, tax-free bonds have been considered to be at bargain rates when they yield more than 85% of Treasuries. Any rise in municipal yields would increase demand by attracting “crossover” buyers from other markets.
Since it would be difficult for Republicans to characterize the president’s proposal as anything but a benefit for the wealthy, it is unlikely to be approved by Congress in its current form.
The message is clear: stay the course. Tax-free bonds are cheap. They have never represented a better value than they do today.
