Dear Shareholder:
These are trying times that try the souls of bond holders (and shareholders of bond mutual funds). The Federal Reserve has now raised the fed funds rate ¼ of 1% seventeen times from an all time low of 1% in June of 2004 to the present 5¼%. And yet, in spite of this tremendous increase in short-term rates, the price of longer term bonds has declined only slightly. Our various Income Series have declined in price an average of 3.5% in the past year which means the dividend earned during that period exceeds the price decline.
But even this small decline in share price has taken its toll upon the minds of a few of our shareholders, usually those with smaller accounts. So our total number of active accounts has dropped about 1% over the past year. Amazingly, our total assets under management have increased somewhat in the past year after adjusting for price decline, so this tells me we have some smart shareholders who have added to their accounts during this volatile year. They have seized the opportunity to buy this steady stream of tax-free income while it is cheaper. They are practitioners of the “milk cow” principal.
The “milk cow” principal started here when a young couple came in to discuss opening an account. When we got to the part where we explained that the price of bonds moved in the opposite direction that interest rates moved, the young wife got fixated on this “risk” and began to waver in her desire to be a new shareholder. Finally, her husband said, “Honey, think of investing as if you were buying a milk cow. The “milk” is the steady stream of tax-free interest you earn. If you bought a milk cow, that cow would be worth a certain price at the local cattle market, which would change from day to day. But you wouldn’t care what the price was as long as you were getting the same amount of milk from day to day.”
With apologies to long-term shareholders who have heard this “milk cow” story more than once, I offer it again because investing in one of our funds is indeed very much like investing in a milk cow. The income is a fairly steady stream that can be counted on, regardless of the price of the shares. So it isn’t really rational to focus on price alone. If you give yourself a reasonably long timeline, price will rise and fall several times giving you a total return that averages something close to the dividend that was paid during that time period. For example, the total return for those Income Series that we offer that have been in existence for ten years is over 5%, mostly tax-free, even though the price is currently at a one year low.
Staying the course through ups and downs in the market maximizes your chances of receiving an attractive total return, mostly tax-free. “Chasing the market” by selling on declines and buying on price rises is a sure recipe for mediocre results.
What is the bond market outlook for the next few months? Anybody who thinks he knows is living dangerously. Nevertheless, letter writers are going to be asked to take a guess and I am probably no exception. So, here goes.
The Citigroup Municipal Market Comment of June 9th points out that rising inflation fears seem to be hitting stocks more than bonds. The folks at Citigroup speculate that this may stem from three or four key factors. First, the Federal Reserve under Bernanke is trusted to fight inflation vigorously. Second, there is a feeling that if the central bank tightens much more it will quickly take more starch out of the economy’s growth rate than had been anticipated. Third, further tightening removes liquidity from the market, making carry trades less viable. Fourth, the upswing in volatility of capital markets has apparently caused some participants to become unwilling to take risks.
The result of all of the above factors is the long-term bond markets have rallied recently while stocks have stumbled. In Citigroup’s view, there is now a real possibility that the peak in long-term rates has already occurred. That is to say in the alternative, prices of bonds may have reached their low. I would add only that the current atmosphere of volatility can be affected by news in ways that result in some bad days and some good days for the next few months until the Fed’s future course can be more reliably predicted. That’s probably not perfection, but it is the best I can do right now.
Speaking of perfection: About thirty years ago I took oil painting classes from William Welch, a highly respected portrait artist, and a retired army colonel. The class consisted of about ten people, three serious students and about seven others that were simply out to find some recreation. Mr. Welch knew who was serious and who was not. So as he circulated around the room, observing each person’s attempt at painting a portrait from a model that was sitting, the patter would go like this: “Oh Mrs. Jones, that’s so nice! Here, let me show you how to put a highlight on that eye. See how it brings out the roundness? Oh, and your brushes are so dirty. Let me clean them for you!” Then he would come to one of us who were attempting to do serious work. “Tom” he would say; “what about the jaw line?” “Well Mr. Welch, it may be a little bit too vertical” “A little bit?” he would reply, “A little bit? Damnit, it’s TOO VERTICAL!” “Do it over” he would shout, while erasing my last hour’s work with a turpentine rag. “And while you’re at it, clean these filthy brushes”. It was quite a learning experience.
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