Thinking of waiting for higher rates? Here’s why the math behind waiting for higher rates might not add up.
After years of low interest rates, investors may have a shot at higher yields. Economic data have improved and the new administration in Washington is talking about fiscal stimulus and tax reform, while, importantly, the Federal Reserve appears ready for further hikes in the federal funds rate. Even so, if you have cash to invest, you’ve just redeemed a bond or you are on a plan that makes regular muni bond investments, it may not be a good idea to wait for higher rates.
Doing the Math
Maintaining a consistent investment schedule—not only adding exposure but also staying invested—is critical. Here’s why: Suppose you have $50,000 to invest. You had been considering a six-year municipal bond paying 1.80% at par but, anticipating a 2.50% yield a year from now, you keep the $50,000 in a tax-exempt money-market fund. Then suppose your assumption about higher rates was correct, and you then invested in the same bond when it yielded 2.50% in March 2018. Would you be ahead of the game income-wise?
Not at all. If you bought the 1.80% bond now you would have earned $900 in income 12 months out (see below). The return from the cash in the money-market fund would have been only $5. Deploying the $50,000 at 2.50% one year from now earns $1,250 during the second year but, as the chart shows, you would still be $550 poorer than if you had gone with the 1.80% bond a year earlier.
At the end of the third year, the total payments from the 1.80% bond would still be ahead of the 2.50% bond. It’s only at the end of the fourth year that the higher-yielding bond outearns the lower one, and then only by $155 on a $50,000 investment.
Anticipating Higher Rates
To be sure, we are not advocates of fully entering the market at once. Like most bond investors, we are concerned about rising interest rates and tax reform, but rather than waiting for higher rates we continue moving ahead anticipating higher rates by tilting the investments toward short and/or intermediate maturities.
Where one may describe the preceding paragraph as “offense” in its advocacy to remain invested to earn a consistent rate of return, “defense”—specifically with mitigating volatility and preserving wealth—is often considered to be even more important. Aside from daily volatility, long-term wealth preservation is considered imperative for buy-and-hold investors. According to Moody’s, the average 10-year cumulative default rate for A, Aa and Aaa-rated municipals stood at 0.07%, 0.02% and 0.00%, respectively, between 1970 and 2015.
The market is currently at the tail end of a period in which bond redemptions are heavy while primary activity is slow. Though this stability is encouraging and yields now hover at two-year highs, we remain concerned as the seasonal factors are currently reversing while the market awaits the details of the president’s fiscal stimulus and tax reform. Volatility is possible, but we do not recommend making considerable changes based on what might happen tax-wise, as muni bonds enjoy exemptions available to few others and their history of creditworthiness bolsters their role in wealth preservation.
Additionally, we would look to use the market’s current stability to strengthen positioning by trading for high-quality bonds that pay above-market coupons of at least 5% while maintaining a neutral portfolio duration. Investors should also note that 80% of the yield curve is currently captured by year 12. Finally, look to gradually add exposure moving forward, but keep some powder dry in case new opportunities arise.
Note: This article first appeared in the March 2017 edition of “On the Markets,” a publication of the Global Investment Committee, which is available on request.
* Cash invested in a tax-exempt
money market fund. Hypothetical performance should not be considered a
guarantee of future performance or a guarantee of achieving overall financial
objectives. For more information about the risks to hypothetical performance,
please see the Risk Considerations below.
International investing entails greater risk, as well as
greater potential rewards compared to U.S. investing. These risks include
political and economic uncertainties of foreign countries as well as the risk
of currency fluctuations. These risks are magnified in countries with emerging
markets, since these countries may have relatively unstable governments and
less established markets and economies.
Bonds are subject to interest rate
risk. When interest rates rise, bond prices fall; generally the longer a bond's
maturity, the more sensitive it is to this risk. Bonds may also be subject to
call risk, which is the risk that the issuer will redeem the debt at its
option, fully or partially, before the scheduled maturity date. The market
value of debt instruments may fluctuate, and proceeds from sales prior to
maturity may be more or less than the amount originally invested or the
maturity value due to changes in market conditions or changes in the credit
quality of the issuer. Bonds are subject to the credit risk of the issuer. This
is the risk that the issuer might be unable to make interest and/or principal
payments on a timely basis. Bonds are also subject to reinvestment risk, which
is the risk that principal and/or interest payments from a given investment may
be reinvested at a lower interest rate.
Bonds rated below investment grade may have speculative
characteristics and present significant risks beyond those of other securities,
including greater credit risk and price volatility in the secondary market.
Investors should be careful to consider these risks alongside their individual
circumstances, objectives and risk tolerance before investing in high-yield
bonds. High yield bonds should comprise only a limited portion of a balanced
Investing in commodities entails significant risks.
Commodity prices may be affected by a variety of factors at any time, including
but not limited to, (i) changes in supply and demand relationships, (ii)
governmental programs and policies, (iii) national and international political
and economic events, war and terrorist events, (iv) changes in interest and exchange
rates, (v) trading activities in commodities and related contracts, (vi)
pestilence, technological change and weather, and (vii) the price volatility of
a commodity. In addition, the commodities markets are subject to temporary
distortions or other disruptions due to various factors, including lack of
liquidity, participation of speculators and government intervention.
Equity securities may fluctuate in response to
news on companies, industries, market conditions and general economic
Investing in smaller companies involves greater risks not
associated with investing in more established companies, such as business risk,
significant stock price fluctuations and illiquidity.
Stocks of medium-sized companies entail special risks, such as limited
product lines, markets, and financial resources, and greater market volatility
than securities of larger, more-established companies.
Value investing does not guarantee a profit or
eliminate risk. Not all companies whose stocks are considered to be value
stocks are able to turn their business around or successfully employ corrective
strategies which would result in stock prices that do not rise as initially
Growth investing does not guarantee a profit or
eliminate risk. The stocks of these companies can have relatively high
valuations. Because of these high valuations, an investment in a growth stock
can be more risky than an investment in a company with more modest growth
Companies paying dividends can reduce or cut payouts at any
Investing in foreign emerging
greater risks than those normally associated with domestic markets, such as
political, currency, economic and market risks.
Investing in currency involves additional special
risks such as credit, interest rate fluctuations, derivative investment risk,
and domestic and foreign inflation rates, which can be volatile and may be less
liquid than other securities and more sensitive to the effect of varied
economic conditions. In addition, international investing entails greater risk,
as well as greater potential rewards compared to U.S. investing. These risks
include political and economic uncertainties of foreign countries as well as
the risk of currency fluctuations. These risks are magnified in countries with
emerging markets, since these countries may have relatively unstable
governments and less established markets and economies.
Asset allocation and
do not assure a profit or protect against loss in declining financial markets.
Because of their narrow focus, sector investments tend to be more volatile than
investments that diversify across many sectors and companies.
The indices are unmanaged. An investor cannot
invest directly in an index. They are shown for illustrative purposes only and
do not represent the performance of any specific investment.
The indices selected by Morgan Stanley
to measure performance are representative of broad asset classes. Morgan
Stanley Smith Barney LLC retains the right to change representative indices at
Morgan Stanley Wealth Management
is the trade name of Morgan Stanley Smith Barney LLC, a registered
broker-dealer in the United States. This material has been prepared for
informational purposes only and is not an offer to buy or sell or a
solicitation of any offer to buy or sell any security or other financial
instrument or to participate in any trading strategy. Past performance is not
necessarily a guide to future performance.
The author(s) (if any authors are
noted) principally responsible for the preparation of this material receive
compensation based upon various factors, including quality and accuracy of
their work, firm revenues (including trading and capital markets revenues),
client feedback and competitive factors. Morgan Stanley Wealth Management is
involved in many businesses that may relate to companies, securities or
instruments mentioned in this material.
This material has been prepared
for informational purposes only and is not an offer to buy or sell or a
solicitation of any offer to buy or sell any security/instrument, or to
participate in any trading strategy. Any such offer would be made only after a
prospective investor had completed its own independent investigation of the
securities, instruments or transactions, and received all information it
required to make its own investment decision, including, where applicable, a
review of any offering circular or memorandum describing such security or
instrument. That information would contain material information not contained
herein and to which prospective participants are referred. This material is
based on public information as of the specified date, and may be stale
thereafter. We have no obligation to tell you when information herein may
change. We make no representation or warranty with respect to the accuracy or
completeness of this material. Morgan Stanley Wealth Management has no
obligation to provide updated information on the securities/instruments
The securities/instruments discussed
in this material may not be suitable for all investors. The appropriateness of
a particular investment or strategy will depend on an investor's individual
circumstances and objectives. Morgan Stanley Wealth Management recommends that
investors independently evaluate specific investments and strategies, and
encourages investors to seek the advice of a financial advisor. The value of
and income from investments may vary because of changes in interest rates,
foreign exchange rates, default rates, prepayment rates, securities/instruments
prices, market indexes, operational or financial conditions of companies and
other issuers or other factors. Certain information contained herein may
constitute forward-looking statements. Estimates of future performance are
based on assumptions that may not be realized. Actual events may differ from
those assumed and changes to any assumptions may have a material impact on any
projections or estimates. Other events not taken into account may occur and may
significantly affect the projections or estimates. Certain assumptions may have
been made for modeling purposes only to simplify the presentation and/or
calculation of any projections or estimates, and Morgan Stanley Wealth
Management does not represent that any such assumptions will reflect actual
future events. Accordingly, there can be no assurance that estimated returns or
projections will be realized or that actual returns or performance results will
not materially differ from those estimated herein.
This material should not be
viewed as advice or recommendations with respect to asset allocation or any
particular investment. This information is not intended to, and should not,
form a primary basis for any investment decisions that you may make. Morgan
Stanley Wealth Management is not acting as a fiduciary under either the
Employee Retirement Income Security Act of 1974, as amended or under section
4975 of the Internal Revenue Code of 1986 as amended in providing this
Morgan Stanley Smith Barney LLC,
its affiliates and Morgan Stanley Financial Advisors do not provide legal or
tax advice. Each client should always consult his/her personal tax and/or legal
advisor for information concerning his/her individual situation and to learn
about any potential tax or other implications that may result from acting on a
This material is disseminated in
Australia to "retail clients" within the meaning of the Australian
Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N.
19 009 145 555, holder of Australian financial services license No. 240813).
Morgan Stanley Wealth Management
is not incorporated under the People's Republic of China ("PRC") law
and the research in relation to this report is conducted outside the PRC. This
report will be distributed only upon request of a specific recipient. This
report does not constitute an offer to sell or the solicitation of an offer to
buy any securities in the PRC. PRC investors must have the relevant
qualifications to invest in such securities and must be responsible for
obtaining all relevant approvals, licenses, verifications and or registrations
from PRC's relevant governmental authorities.
If your financial adviser is
based in Australia, Switzerland or the United Kingdom, then please be aware
that this report is being distributed by the Morgan Stanley entity where your
financial adviser is located, as follows: Australia: Morgan Stanley Wealth
Management Australia Pty Ltd (ABN 19 009 145 555, AFSL No. 240813);
Switzerland: Morgan Stanley (Switzerland) AG regulated by the Swiss Financial
Market Supervisory Authority; or United Kingdom: Morgan Stanley Private Wealth
Management Ltd, authorized and regulated by the Financial Conduct Authority,
approves for the purposes of section 21 of the Financial Services and Markets
Act 2000 this material for distribution in the United Kingdom.
Morgan Stanley Wealth Management
is not acting as a municipal advisor to any municipal entity or obligated
person within the meaning of Section 15B of the Securities Exchange Act (the
"Municipal Advisor Rule") and the opinions or views contained herein
are not intended to be, and do not constitute, advice within the meaning of the
Municipal Advisor Rule.
This material is disseminated in
the United States of America by Morgan Stanley Smith Barney LLC.
Third-party data providers make
no warranties or representations of any kind relating to the accuracy,
completeness, or timeliness of the data they provide and shall not have
liability for any damages of any kind relating to such data.
This material, or any portion
thereof, may not be reprinted, sold or redistributed without the written
consent of Morgan Stanley Smith Barney LLC.
© 2017 Morgan Stanley Smith
Barney LLC. Member SIPC. All rights reserved.
CRC 1718141 (2/17)