Money Morning Mailbag: Short-Term Maturities Are the Best Bet for Tax-Free Municipal Bonds

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Question:  We have some money invested in tax-free municipal bonds, but read in the local newspaper that with the potential rise of interest rates these bonds tend to do poorly. Can you better explain this, and if this is the case, what do you recommend?  I appreciate your input. Thank you.

- Joan

Answer:  Due to the huge federal deficits, continuing inflation and the huge commodities bubble now underway, a substantial rise in long-term interest rates is inevitable, no matter what happens to short-term rates. The Federal Reserve Board's present policies show it will delay raising short-term rates as long as it can, but will eventually be forced to raise them.

My advice on the tax-free bonds depends on their maturity. In general, tax-free bonds become relatively better investments as tax rates on investment income rise, as they seem bound to do for the next few years. However, long-term bond prices can suffer large capital losses as interest rates rise - this was a problem for a lot of banks in the 1970s, for example. At present interest rate levels, those capital losses can overwhelm the income from the bonds.

Hence any holdings of tax-free municipal bonds (munis) should be of no more than five years maturity. These shorter maturity bonds will suffer only modest capital losses, and you can always wait until their maturity, when you can cash them in at par.


Like all bonds, tax-free municipal bonds are at risk from rising inflation. This risk can most easily be balanced by modest holdings in the gold and silver exchange-traded funds SPDR Gold Trust (NYSE: GLD) and iShares Silver Trust (NYSE: SLV). The latter is probably of better value currently.

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