Were you among the muni investors in the 1970s and ‘80s who found themselves with bonds paying 4.00% or even 6.00% that were suddenly trading at 50 cents on the dollar?
Recently, a client shared his memories of those days. He noted, happily, that he was a buyer at the time but lamented the predicament of investors who had paid full price for their bonds. He also expressed concerns that a similar scenario may be unfolding today.
What he didn’t realize however, was that his sympathy for those bondholders was misplaced. In fact, given the flexible nature of munis, investors were able to take advantage of the situation, and actually reap an additional benefit. There is an important message here that is helpful for today’s investors also.
A simple strategy
During that high-interest rate period of 30 to 40 years ago, we encouraged investors with depressed long-term bonds to simultaneously exchange them for other bonds with similar coupons and maturities that were selling at the same price – a “tax swap.” This enabled them to establish substantial losses for tax purposes without losing their position in the market and without missing a day of interest.
Inevitably, that spike in interest rates purged the economy of inflation, causing interest rates to decline and in a reasonably short period of time, those 6.00% bonds were once again worth 100.00 or more.
These investors then had tax losses to use for offsetting capital gains or reducing their adjusted gross income by $3,000.00. Any unused losses were carried forward dollar for dollar to be used in ensuing years, so the original 6.00% yield they bought turned out to be considerably higher when tax savings were factored in.
A similar strategy is not possible with stocks. If investors wish to establish a tax loss but also maintain their position in a losing stock, they have to wait 31 days to buy it back. They would then be subject to the vagaries of the market. If the investor bought the stock back immediately, the IRS would deem it a “wash sale,” and ineligible for a tax loss.
It was during this period we became acutely aware that buying long-term bonds and maximizing tax-free income were the keys to successful municipal bond investing, and attempting to time the movement of interest rates is folly. Equally important, the additional cash flow produced by long-term bonds is available for reinvestment at higher rates if and when they present themselves.
This much is clear: the flexibility of high quality, long-term municipal bonds is an important advantage. And investors who keep their eye on the ball, buy bonds when investment dollars are available and maximize reinvestible income, are always pleased they do.
