Buy bonds now or wait for rates to rise?

I believe that fixed income investors value municipal bonds for their tax-advantaged income, credit quality and predictable interest payments.

Municipal bonds are tax-exempt fixed-income securities issued by states, cities, counties and other governmental entities to raise money to fund projects for the public good, such as building schools, highways and hospitals. State of Nevada, Carson City and Carson Tahoe Regional Medical Center have all historically been issuers of municipal bonds.

The issuer promises to repay your principal in full at the bond's maturity, in addition to paying you interest income - which is generally exempt from federal income tax. For states that assess a state income tax such as California, they also may be exempt from state and local taxes as well. As an asset class, municipal bonds offer a degree of credit quality that is second only to U.S. Treasury and Agency debt.

I notice Nevadans have a preference to purchasing bonds in-state, but buying "out-of-state" municipal bonds may be beneficial. As residents of a state with low bond issuance, our selection is often limited and purchasing out of state bonds can help to diversify portfolios and, in some cases, provide a yield advantage.

Investors who are residents of states with no state income tax such as Nevada can purchase municipal bonds from any state as there are no state tax implications. Putting aside any Alternative Minimum Tax concerns, tax-exempt municipal bonds will be both federal and state income tax-exempt for Nevadans. In addition, bonds issued by states that have relatively low or no state income tax can often be viable alternatives to "in-state" bonds; they frequently carry higher relative yields versus bonds from states with higher income tax rates and otherwise similar characteristics (e.g. credit quality, maturity, yield).

With the economy in recovery, many investors have welcomed the transition to a steeper yield curve environment, while I see others still are concerned about inflation and market volatility. However, with intermediate to long-term municipal bond yields now increasing, it may take several years to recoup the interest income investors may forego by sitting on the sidelines with allocation strategies that may be over-weight in cash and money market accounts, instead of investing resources in potentially higher-yielding, longer-term municipal bonds.

Investors may want to consider the following two scenarios which highlight the "potential cost of waiting" given a hypothetical shift to higher interest rates over the next 12 month period.

Assumptions:

1. $1 million investment in municipal bonds.

2. 45 basis point increase in intermediate-term (10-year) municipal rates over the next 12 months.

3. 0.01 percent money market account rates over the next 12 months.

Scenario 1

Purchase a 10-year tax-exempt municipal bond yielding 3 percent.

Scenario 2

Remain in a tax-exempt money market account for one year at 0.01 percent, and then invest in a 10-year tax-exempt municipal bond hypothetically yielding 3.45 percent, or 45 basis points higher than prevailing intermediate-term (10-year) municipal rates.

In this example, it takes an investor eight years to recoup the lost interest income caused by remaining in money market account for an additional 12 months.

With the recent transition to a steepening yield curve, now may be an appropriate time to consider adding longer-term municipal bonds to your portfolio.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of Morgan Stanley Smith Barney LLC. He can be reached at William.a.creekbaum@mssb.com or 689-8704.