Tuesday, May 17, 2011

The Problem With Low Interest Rates (Continued)

Interest rates continue to grind lower, defying the predictions of inflation bears and deficit doomsayers.

The yield decline has been broad-based, with rates on most bond types declining.

As I wrote last week, yields are so low now on bonds that it presents a real challenge for investors.

For example, I have a number of clients who invest in municipal bonds. Munis, of course, offer tax-free yields and, if held to maturity, good principal protection.

According to Merrill Lynch, as of yesterday the 10 year Treasury has decreased by 43 basis points over the last 25 trading days.

Meanwhile, the 10 year AAA Muni rate has decreased by 65 basis points over the same time period, to 2.62%. High quality muni yields are now where they were in early November 2010.

The strategy of many investors has been to keep the maturities of their bond holdings relatively short, hoping for rates to move higher. Now, in order to earn more than 1% on munis you have to go out at least 4 years, which hardly seems to be worth it, in my opinion.

Buying short maturities has been a losing strategy for several years now, as Citigroup's veteran muni strategist George Friedlander wrote in his regular Municipal Market Comment last Friday:

It is also important to note that, in our experience, far too many investors are "huddled" in very short maturities, waiting for higher Treasury yields to pull muni yields higher all along the yield curve. We frequently speak to investors who have taken this approach since roughly 2004! The amount of income left on the table by investors utilizing this approach remains extremely high, given the steep slope of the muni yield curve.

I have some thoughts on investment alternatives over the next few posts, but for now my one strong recommendation is to avoid investing in short (under 5 years) munis. If you want fixed income, and don't want to stay in a money market fund, consider just adding Treasurys for the short term.