Gil’s Musings

Interest Rates? Lower for Longer

I know I write a lot about the bond market. But bear with me for one more. There are several reasons I do this. First, many of my clients are conservative investors and they have a preference for safety, so I spend a lot of time looking for bonds. Second, bonds are the soul of the investment markets. The reasons are simple. Interest rates drive investment decisions. When we compare risks and rewards in any investment, real estate, munis, stocks, etc., we always compare the possible returns to the “risk-free-return” in US Treasuries. As interest rates have nose-dived as a result of many factors, we can see the psychology of investors showing up in interest rate graphs. One thing you must remember is that consensus is what most people believe. That does not make it correct. As a matter of fact, I think betting against consensus is one of the most predictable ways to enhance performance.

This is a graph of current interest rates in the pre-refunded municipal bond market:

Segment Wealth Management Yield To Maturity Chart

Pre-refunded munis are tax-free bonds that are not eligible to be called currently, but they would be if they could be. So the issuer calls the bonds at the first future date and says so now. They usually then buy US Treasuries to match the call principal value and they escrow those bonds at a bank, to put their money where their mouth is. The rating agencies then consider the obligation negated and they allow the municipality to issue new bonds if they like, without a credit adjustment. Due to the efficiencies in the interest rate market, prices and yields dynamically ebb and flow based on many factors affecting supply and demand. Prices and yields move in opposite directions so that the more you pay for a bond, the less its fixed coupons will yield over its life. Look closely at the graph above and you will see the thinking of many investors about their views of the future of interest rates. The graph shows an abundance of investor dollars chasing super-short maturities, driving the yields very low. Fewer dollars are looking at 24-36 month paper, hence the yields rise and rise some more, trying to tempt them with each successive tick. Then at 36 months the yields flatten for 24 months. This shows that investors think in 3-year and 5-year increments. It also shows that they are strongly opinionated about what the next 5 years hold, but beyond that is anyone’s guess.

If we were to look at un-refunded munis, plain old State of Texas GO for example, we would see longer maturities (municipalities rarely pre-refund more than 5 years into the future). If the chart were to continue out to 25 years or so, you would see that beyond 12-15 years, the available yields generally stop rising. There are several reasons for this. The most important is that most munis are callable within 10 years of issuance and bond holders calculate their risks accordingly. Another is the arbitrary nature of decision making. Long terms like that become somewhat nebulous and people tend to pay more attention to simply buying issues close to home.

What I would gather from this graph is that super-short term investors are leaving quite a bit of additional yield on the table by not stepping out to 3 years. Additionally, more yield oriented investors should consider selling their bonds now that are due in the next 2 years (prices are very high) and re-purchasing bonds in the 5-7 year range where the prices are lower (indicated by higher yield).

Yes, I know interest rates can only go to zero and we are already there. Yes, I know that rates are more likely to rise than fall. I give you two thoughts: 1) That’s what they said in Japan 25 years ago, where their interest rates have been hovering at 1% since then. 2) Think of your bonds in cumulative interest format. If you have a 5 year bond paying 2% per year, then you will surely make 10%. How many years are you willing to wait at 0.10%? For every 2% you miss waiting, rates have to rise by that amount during your term. If you spend 3 years waiting, and I’ve already earned 6% (3×2%), at that time two-year rates have to be at 4.65% for you to catch me in five years… not likely.

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