(For the video version of this article click: Offense & Defense - How To Win The Game With Muni Bonds.)
If we were to play a soccer game and only had offensive players on the field, chances are we would score quite a bit, but at the same time, we would be scored on a lot as well. If we were to play with only defensive players, we could likely defend against being scored on, but we would have little chance of scoring ourselves.
Therefore, we need to play with both offensive and defensive players simultaneously to maximize our chances of both scoring and protecting our goal. It's similar with regard to investing in municipal bonds.
While most municipal bond issues are bought for income and do not trade until they either mature or are called, when you are buying your bonds, at times it makes more sense to be defensive and at other times it makes more sense to be offensive.
The most important factor though, is to buy bonds that have VALUE. We will get into value in a moment, but first let's define offense and defense with regard to investing in bonds. Offense would mean buying a bond for the maximum income we can get, regardless of the length of maturity or price.
Defense means buying a bond with the intention of protecting against a loss of principal from rising interest rates. It includes setting yourself up for an opportunity to swap into higher yielding, longer bonds when the market changes and presents a better opportunity to lock in a higher income at a lower price.
When should we play offense and when should we play defense?
There are opportunities to play both in most markets. However, in a higher interest rate market, obviously we are going to be more focused on locking in higher yields (offense), and consequently will have less concern over the length of maturity and more concern over the coupon, the price and the yield we can achieve.
In a lower interest rate environment, we are still interested in generating the maximum amount of income we can get, but we also have a heightened awareness of downside risk (i.e. Decline in market value) (defense).
Let "Value" be thy guide.
Aim to purchase bonds when they have VALUE, whether they are defensive or offensive. A bond has value when it is cheap relative to the market.If you can buy a 5 year muni at a 4% yield when the market is coming out with 3.5% 5 year munis for equivalent quality, that is VALUE.
If you can buy a 25 year bond at a 6% yield when the market is coming out with 5% 25 year bonds for equivalent quality, again, that is VALUE.
The 5 year bond is defensive relative to the 25 year bond, as short term bonds have less room for their price to move, even if rates change substantially. Conversely, the 25 year bond is offensive, as we are focused on the higher income, and are giving less consideration to the potential volatility in the price.
Remember, no one knows where interest rates will go. Therefore it makes good sense to maintain both defensive positions and offensive positions.
If interest rates remain low for an extended amount of time, one would expect that your offensive positions would provide more income than their defensive short term counterparts (Obviously, call features must be considered which could result in risk of reinvestment of principal at lower rates).
If interest rates go up, your defensive positions set you up with an opportunity to swap into longer bonds whose prices might have come down substantially due to market conditions. As a bond investor, understanding how to apply the concepts of offense and defense, as well as buying "value" are instrumental in maximizing the performance of your bond portfolio.
Investing in municipal bonds involves risk, including market fluctuations and potential loss of principal. This has been produced solely for informational purposes and is not to be construed as a recommendation of any particular investment or investment strategy. It is also not a solicitation or an offer to buy or sell any securities or related financial instruments. You should consider consulting a broker or investment professional before investing or implementing any investment strategy. The preceding presentation is based on information obtained from sources believed to be reliable but no independent verification has been made, nor is its accuracy or completeness guaranteed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.