For Bond Investors, Is It Worth the Wait on Rates?

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.

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. 

Now or Later? Comparing a Hypothetical Investment

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.

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. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.