Last week, the Investment Co. Institute released the news that mutual fund sales had increased a record $12.3 billion during October. Of that amount, $7.7 billion flowed into Government National Mortgage Association pass-through funds, long-term municipal funds and government income funds.
In other words, the bond market rally of the past three months has driven interest rates on Treasury bonds with maturities out to 10 years below 10 percent. At the same time, short-term rates on certificates of deposit and money market funds, etc., have fallen to the 7.5 percent level or lower.
Consequently, investors who have been spoiled over the last five years with fat double-digit interest rates, especially on money market types of investments, are beginning to stretch for more yield or income by lengthening investments. Hence the move into mutual bond funds that offer much higher returns but, by their nature, are composed of bonds with long-term maturities. And like it or not, that creates risks for the investor.
There are two kinds of risk: credit risk and market risk. Credit risk refers to the ability of the issuer to pay the principal and interest on an isssue. Market risk refers to the protection of ones' principal from interest rate swings in the market.
Prices and rates move in opposite directions. Higher prices go with lower rates and, conversely, lower prices go with higher rates. Also, the longer the maturity, the more volatile the change in price when interest rates rise or fall. Interest rates usually follow declines for a period (recovery phase) and then, as the economy heats up (the expansion phase), rates will rise and cool off the economy (recession phase), at which point rates will decline again. It's sort of a thermostat role for interest rates.
Investors who lengthen maturities by moving from short-term money market funds, etc., into longer bond funds in hopes of increasing their income should be aware, at least, of the risk to their principal should interest rates turn higher. Even though a fund may be composed of all Treasuries with no credit risks, should interest rates move higher, the value of the fund's shares may decline.
Consequently, when investors purchase a long-term fund, they should understand that, if interest rates move higher, they might be forced to stay in that particular fund for a long period of time because of losses sustained in the value of their shares. It even could be for the length of a particular business cycle. Ideally, investing in long-term funds should be the same as investing in individual long bonds. Buy them when the yields are high, and sell them when yields are at their lowest, not the other way around.
Ironically, just when all other interest rates are declining, interest rates for short-term tax exempts (3- 6- and 9-month maturities) have rocketed higher by 100 basis points in the past three weeks.
Several technical factors are responsible for this reversal in rates. Billions of dollars of new short-term issues are pouring into the marketplace before year's end.
One issue, the New Jersey Turnpike Authority, totaled $2 billion, of which $1 billion was in maturities that ran out into 1986. They were attractively priced, and buyers of this issue sold $1 billion of issues they owned to pay for the New Jerseys on Nov. 21. This added inventory, plus the deluge on new issues, forced the short-term yields to jump.
Analysts expect the upward pressure to continue through December and then to decline therafter. If you are a buyer of short-term tax exempts, get your bushel basket out now.