MUNICIPAL BONDS: THE COST OF WAITING FOR HIGHER …

MUNICIPAL BONDS: THE COST OF WAITING FOR HIGHER RATES

WHAT IS THE COST OF WAITING? Not many investors can get excited about investing in municipal bonds with interest rates near their 50-year lows. But as rates have risen recently, many are struggling with the question of whether to invest now or hold out for the possibility of capturing even higher yields down the road. While no one can predict when and by how much interest rates will change, the cost of waiting is quite clear.

THE TIME VALUE OF MONEY The old saying goes, "A bird in the hand is worth two in the bush." The same logic may apply to investing. When faced with a decision to invest today or wait, it is important to understand that the longer an investor holds out in hopes of higher yields, the more rates will have to increase to make up for interest forgone today.

Further, interest on money invested today can be reinvested to earn additional interest. Through this principle of compounding, it is clear that waiting for interest rates to rise becomes more expensive relative to investing today.

REAL WORLD EXAMPLES Consider the following scenarios in which an investor has the option of investing in a five-year municipal bond today, or remaining in cash over the same time period.

Under the first option, an investor buys a five-year municipal bond today at a yield of 2.80 percent. On a $100,000 investment, the investor earns $2,800 each year. Under option two, the investor remains invested in a municipal money market fund that initially yields 0.38 percent. Under the worst case, Scenario One, rates remain the same throughout the five years, earning the investor $12,100 less than what would have been earned by investing in the municipal bond. Under an optimistic case, Scenario Four, rates increase a total of 7 percent over the five-year period. Still, this scenario earns the municipal money market investor $800 less than would have been earned by investing in the municipal bond today.

As the table below illustrates, an investor would have to correctly guess the timing and magnitude of an interest rate increase to win at this game. Further, the longer it takes for rates to rise, the harder it is to make up the interest lost to waiting.

ILLUSTRATIONS

Option One: Purchase Five-Year Municipal Option Two: Remain in Municipal Money Market Fund with an intial 0.38% Yield Bond with a 2.80% Yield to Maturity

Year 1 2 3 4 5

Annual Interest 2,800 2,800 2,800 2,800 2,800

Scenario One

Change in Rates

Annual Interest

--

380

--

380

--

380

--

380

--

380

Scenario Two

Change in Rates

Annual Interest

+0.5%

880

+0.5%

1,380

+0.5%

1,880

+0.5%

2,380

+0.5%

2,880

Scenario Three

Change in Rates

Annual Interest

+1%

380

+1%

1,380

+1%

2,380

+1%

3,380

+1%

4,380

14,000

1,900

9,400

11,900

Scenario Four

Change in Rates

Annual Interest

380

380

+1.0%

1,380

+2.5%

3,880

+3.5%

7,180

13,200

Based on $100,000 initial investment. This is for illustrative purposes only and is not indicative of any investment. Past performance does not guarantee future results. Piper Jaffray does not provide legal or tax advice.

Since 1895. Member SIPC and NYSE. 8/03 PA-03-1530

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