Gosh, how time flies when you’re waiting for higher interest rates.
It’s hard to believe that two years have passed since I wrote my original article discussing the risk investors unwittingly take when they opt to stay on the sidelines, waiting for higher rates, before committing their funds to the bond market.
In May 2001, I was tired of hearing people say that rates were at historical lows and had nowhere to go but up, so I decided to illustrate the point that “timing” the tax-free bond market is a futile pursuit for the individual investor.
In our first “Cost of Waiting” article, we created two hypothetical investors, each with $100,000 earmarked for tax-free bonds. At the time, long-term AAA insured bonds could be purchased to yield 5.60%.
Our Investor A, recognizing the folly of trying to predict the future, put his money to work in these long-term bonds at 5.60%. Investor B, on the other hand, watched CNBC every day and gleaned from financial gurus that interest rates were at “historic lows” and would soon be moving higher. Accordingly, he decided to park his money in a tax-free money market, paying 2.25% and wait for bond rates to make their inevitable move to 6.00% or higher.
You know what happened next
Here we are two years down the road and Investor B still hasn’t seen long rates on quality munis move up to 6.00%. In fact, they have declined to 5.00% or less. To make matters worse for Investor B, his money market return is down to .35%, well below the rate of inflation.
Meanwhile during this two-year period, the “less sophisticated” Investor A has received $11,200 in tax-free income and has seen his bonds appreciate by about 5%.
Investor B, on the other hand, has averaged 1% in the money market for the two-year period, giving him an additional $2,000 – but leaving him $9,200 behind Investor A. To put this into perspective: even if Investor B is able to buy AAA insured tax-free bonds six months from now at 6%, it will take 30 years for his income to equal that of Investor A.
It appears that Investor B’s strategy was a mistake. He now needs to be careful because mistakes often spawn more mistakes. Investor B now has three options:
He can remain in the money market and continue to wait. He may be enticed into “reaching for yield” by buying bonds rated below his comfort level. Or he can stop over-thinking the subject and purchase AAA insured bonds yielding 5% tax-free.
Can you guess the right choice?
We began this “Cost of Waiting” series to illustrate a concept that is difficult for many individual investors to comprehend, especially if they are new to fixed income investing.
A good analogy can be found in the lesson learned by labor unions back in the 1950s. The unions found that if they went on strike for higher wages and stayed out for too long, even if they received the wage increase, they were never able to make up the money lost when they were on strike. Subsequently, they started to focus on increased fringe benefits and pensions.
Traditional municipal bond buyers, rather than adhering to the stock market’s “buy low, sell high” mentality, realize they are invariably better off committing their investment funds to the market when available. As one of our long-time clients says, “My interest clock is always ticking”.
I couldn’t have said it better.
