In an earlier column, we discussed the tendency of some bond investors to try to outguess the market. Dissatisfied with today’s yields, their strategy is to park investment dollars in money market funds and wait until long-term interest rates rise. We compared their thinking – that interest rates are too low – to those investors who don’t profess to know where interest rates are headed and instead try to maximize the return on their investment dollars as soon as they are available.
Let’s revisit these competing strategies and see which one has fared better.
Two scenarios
Our scenario back in July 2001 was that two investors each had $100,000 earmarked for a tax-free bond investment. At the time, they had the opportunity to buy insured tax-free bonds yielding 5.60%.
Investor A, who didn’t think he could predict future interest rates, bought the highest yielding insured bonds available (5.60%).
Investor B was convinced that rates were going higher. He thought that if he waited, he could soon buy insured bonds yielding 6% or more. So he parked his $100,000 in a tax-free money market paying 2.25% and waited to take advantage of the higher rates he was certain were right around the corner.
Which strategy paid off?
Paying to wait
Investor A’s 5.60% bonds have paid $4,200 since July. Investor B, waiting for higher rates, has seen the interest rate on his money market drop to .75% and has earned an average of 1.50% or $1,125.
Investor B would probably be surprised that he has already earned $3,025 less than Investor A. He might also be startled to learn that even if he could buy a 6% bond today, it would take more than 7½ years for his return on capital to match Investor A’s. Unfortunately for Investor B, long-term tax-free bond rates are no higher than they were nine months ago. In fact, they are slightly lower.
But Investor B is undeterred. He is determined to wait for that magical 6% yield and expects to see it within the next six months. If he is correct, and is also fortunate enough to average 1.25% in the money market for the six months he is waiting, it will still take him over 14½ years to catch up to Investor A. That’s because Investor A, by the end of the six months, will have earned $7,000, or $5,250 more than Investor B, who will have earned only $1,750 in the money market.
Of course, if Investor B guesses wrong, he’ll never catch up.
Waiting is risky
Investors rarely consider the cost of waiting. If they do, they have a tendency to understate it. But just like other risks, such as credit risk or market risk, there is a risk in waiting and it can be significant. It costs investors time and money they may never recoup.
We will continue to monitor our two hypothetical investors and check back in six months. Meantime, we advise investors to avoid trying to outguess the market. If you have investment dollars for tax-free bonds, then put them to work now. Waiting erodes your return.
