Over the past few
months most subscribers have become accustomed to me
extolling the benefits of tax-exempt bonds. I have
written about various types of tax-exempt bonds, how
to look at tax-exempt bonds in relation to Treasury
bonds, different portfolio structures, and municipal
default rates. With markets in a continued flux and
with volatility in interest rates seeming to become
the norm instead of the exception, investors must
become constantly vigilant of the relationship between
various types of bonds.
Over the past two
months investors have seemingly had a change in
psychology and have been snapping up short term
tax-exempt bonds as a safe haven for their new found
stock market profits. The demand has been so great in
fact that the short-term municipal bond yields have
come down drastically. These rates have been brought
down so low that it is now more advantageous for some
investors to consider taxable bonds for there short
term investments. In an earlier writing I discussed
the relationship between tax-exempt bond yields and
U.S. Treasury yields. I suggested that on the short
end (1-5 yrs) that investors should try to buy bonds
whose yield is 70% of the comparable U.S. Treasury
rate. The current two-year rate on the U.S. Treasury
is 6.10%. 70% of that two-year Treasury rate would be
4.27%. This current relationship would seem to suggest
that buying tax-exempt bonds for the short term would
still be the correct decision. However if investors go
beyond the U.S. Treasury market and look at U.S.
Government Agency bonds instead they will find the
possibility for increased returns. This is especially
true for investors in the 28% and 31% tax brackets.
U.S. Government Agency bonds carry a AAA rating and
are issued by institutions such as Fannie Mae (Federal
National Mortgage Association), Freddie Mac (Federal
Home Loan Mortgage Corporation), and Farmer Mac
(Federal Farm Credit Bank) just to name a few of the
more prominent agencies. Investors can currently (as
of 9-20-00) pick up yields of 6.50% to 7.00% on many
of these short-term agency bonds. Even after
considering the after tax yield many investors will
find the yield to be higher than what they would
otherwise receive in tax-exempt bonds. Use the
tax-equivalent conversion chart included with this
letter to help determine whether these U.S. Agency
bonds would be of benefit to you. There are basically
two markets in the U.S. Government Agency bonds, those
that are callable and those that are non-callable.
Callable bonds typically provide the issuer with the
advantage by offering the ability to call in his bonds
if interest rates go down during the call period.
However investors are picking up 75-100 basis points
and more to accept this call risk.
Investors who are
looking to capture capital gains through price
appreciation should stick to non-callable bonds. The
non-callable bonds price will rise quicker in a
falling rate environment and also provide more
liquidity.
If you are slightly
more adventurous then consider take a look at U.S.
Corporate bonds. Specifically those that carry the
investment grade rating of Baa by Moodys and BBB by
S&P. These corporate bonds offer a substantially
higher yield than agency bonds but with manageable
risk in most cases. The Baa/BBB rated bonds in the
corporate market can be a mine field so you have to do
your homework. If you have a question let me know.
