Protecting Your Tax-Free Income From Rising Interest Rates

Alan Appelbaum
Published August 29, 2012

Interest rates have steadily gone progressively downward for over 30 years. If you had listened to most “experts” over the last decade, they were saying that interest rates would be going up. Their logic seemed irrefutable – but as is the case many times when predicting rates – they were dead wrong. Rates on tax-free bonds through the last decade have very steadily gone down.

If you were one of the smart and/or lucky investors not to have listened to your favorite “interest rate guru” – you purchased long term bonds over these years and have enjoyed much higher yields than the people who stayed in cash, money markets, or short term bonds at the behest of the “experts” who said “rates are going higher and soon”.

But now you have a portfolio full of long term bonds, and even you who believed in them are starting to think that interest rates over the next few years should be going up. After all, how long can these rates stay so low? That is a great question. You, however, do not need to answer it correctly to make a sensible move to protect yourself from higher rates should they come along.

The following is an example of an exchange that if repeated several more times with similar circumstances in your portfolio will protect the income you now have on those long term bonds but at the same time shorten your bonds’ maturities a great deal.

You own and would sell:

You would purchase:

What have we done here? What have we accomplished?

  1. We have shortened your maturity by 11 years without losing any income: $5,500 in both investments. This is a very important point and will be discussed later.
  1. Actually increased the quality of the bonds from BBB to BBB+. This is important only if you still have a high regard for the rating agencies’ opinions.
  1. Maintain par amount of 100M.
  1. Actually receive principal back from the transaction ($500).
  1. Assuming original purchase ofEriebonds were at $100.00 – you have appreciation of $5,000.00.
  1. Call feature is very similar (both in 2018).

Shortening the bonds by 11 years without losing income is extremely important. If both lots of bonds don’t get called in 2018 (the first time both can be called), then you are still sitting with a twenty year bond in the case of the Erie’s while only owning a nine year bond if you have the Sarasota’s. The point is that if rates are up in 2018, a 20 year bond is not the place to be – especially if you can be in a 9 year bond, with no loss of income. If both bonds get called, then there is less of an advantage of doing a trade like this. However, since your income is the same and quality is a bit better, you take a profit and you get principal back in your pocket. Why not do it? You are protected either way.

Basically what you have done here is to keep your income the same and have a maximum maturity of 2027 rather than 2038. This kind of trade over the years has been hard to accomplish. But things are different in the world of bonds today and these anomalies do exist!!

For more information, please your HJ Sims broker.

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