Dear Shareholder:
Form 1099 INT makes its’ debut: On or around January 31st we will send you a Form 1099 INT which reports “Interest Income”. This will be the first time we have sent you this particular form. The income you received from any of our tax-free funds will be listed in a box entitled “Tax-exempt interest”. This interest is still tax-exempt as it has always been, free from both Federal and State Income tax. For years the Internal Revenue Service has been asking for this information on your income tax Form 1040. Now they are requiring us to report it on Form 1099 INT.
Enclosed with this letter is a full explanation of the various other federal tax forms you may also receive. Please read this information carefully and retain it for your records.
A Strange Year for the Bond Market (and related topics): I have been in the bond business for over fifty years. It has been accepted knowledge during this time span that if the Federal Reserve raises the short term Fed Funds interest rate, medium and long term rates on bonds rise as well. You could count on it!
As interest rates rise, the price of bonds fall (along with the price of mutual funds that own bonds such as our funds). So in May of 2004, when the Fed Funds rate was 1.00%, and the price of our largest bond fund was $7.48, the Federal Reserve Board began to raise the Fed Funds rate. It raised this rate by .25 of 1% at each meeting until finally, two years later, in late June of 2006 the Fed Funds rate reached 5.25% and stopped there. Normally, the price of our fund would be, say, $7.10 at this new level of Fed Funds rate. Instead, the price was $7.40, down only 7 cents. It was as if the market was saying to the Fed, “You are pushing this short rate too high. I’m not going to follow.” This is the famous interest rate “conundrum” that then Fed Chairman Alan Greenspan spoke of, and it continues to be a conundrum to this day.
What next? Well, something has to give. If the economy continues to slow and inflation stays in check, the Federal Reserve will have to begin to lower the Fed Funds rate, easing money, and the municipal bond market may gradually rise as this is done. On the other hand, if the economy does NOT continue to cool (especially housing prices) and inflation again becomes a concern, the Fed will hold at this level, or even increase the Fed Funds rate again.
Which is the correct choice? It is almost impossible to know. The first scenario has the support of Bill Gross and all the PIMCO economists. The second scenario has the support of Stephen Roach and the economists of Morgan Stanley. Both sides are respected for their ability to call the shots correctly and they don’t agree.
So, what would I do right now? First, I would decide whether I am a long term investor or a short term investor. I personally am a long term investor, so I really don’t focus on which way the market goes. I am going to buy an average price over time. My expectation is to make the current yield on the fund, and every indicator suggests that if I give my investment a five year time line I’ll accomplish that.
If you decide, however, that you are a short term investor, I think I would advise you to get into a money market account (taxable) and be ready to jump when you see one of the above two scenarios start to evolve. But if you do this, remember, it is almost impossible to succeed at market timing. And it is especially risky to be trying to time the market when you have a normally reliable indicator like the Fed Funds rate that is out of sync with the longer term bond market. Like having a compass that isn’t working correctly; it can lead to a big mistake.
On Compasses Not Working: I was witness to an accident caused by a defective compass while I was navigator aboard a Navy Destroyer. We were part of an Anti Submarine screen for two large aircraft carriers. We regularly refueled the Destroyers by going alongside a carrier, passing over fuel lines and replenishing our fuel tanks. This took some careful steering to avoid being sucked into the side of the carrier but also staying close enough to avoid jerking out a fuel line while fuel was being pumped.
The best way to steer this narrow course was to use your gyro compass. A typical order to the helmsman was “steer 260 degrees, steer 259 degrees, etc.” Unfortunately, our gyro compass was shut down for servicing and was not going to be available for the refueling operation. We were steering by an auxiliary magnetic compass. We had a brand new Skipper, fresh out of the War College, who was reluctant to request permission to not refuel until we could get our gyro compass up and running.
I was Navigator but I had to go to a sea station for refueling. Before leaving the bridge I warned the Captain that the magnetic compass might precess (deviate) in the magnetic field of the carrier and that he should give the helmsman rudder orders instead (left five degree rudder, right five degree rudder, etc.) I could tell he was ignoring me. Fortunately for me, the quartermaster recorded my warning in the ship’s log.
You must have guessed the rest. The magnetic compass did precess as we approached the carrier and the helmsman followed it, turning into the side of the carrier. The flight deck of the carrier took off much of our radio antenna, radar and blinker signal light equipment. One blinker light, weighing about 100 pounds hit the deck maybe three feet from where I was standing, reminding me to be thankful that I am alive to tell it.
So, it makes me a little uneasy when a direction indicator like the Fed Funds rate doesn’t seem to be working either.
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