Monday Muni

by Pat Luby

Low Yield ≠ Low Return

This is What Political Risk Looks Like

Market Context Updated

Low Yield ≠ Low Return: Low yields do not have to mean low return. Buy and hold bond investors generally know what their “upside” is–the Yield to Maturity. Active investors seek to combine the coupon income with capital gains. Consequently, total return indices (such as the Barclays Agg) calculate the combination of interest earned with the gain or loss in market value based on the changes in rates for the period. Total return can be negative–if the amount of principal lost is greater than the amount of interest income earned. Muni bond investors especially should be mindful that capital gains are taxable.

As of the end of April 2016, Barclays reports the following total returns:

  • U.S. Aggregate
    • April                0.38%
    • YTD                  3.43%
    • 12-months    2.72%
  • Muni Bond
    • April                0.74%
    • YTD                  2.42%
    • 12-month       5.29%

Why should you care? Because there are so many voices trying to encourage investors to time interest rates, they can’t be faulted for thinking that they should avoid bonds when rates are low. However, most often, the best course is more nuanced than the black and white counsel of buy/don’t buy bonds. It always depends on the goals of the investor–if the objective is to achieve a particular goal, bonds are generally included first and foremost as a non-correlating asset for the equity allocation. Most investors need equity risk for long-term growth, but the biggest influence on reaching a goal is not necessarily the amount earned–very often it can be the amount of losses avoided. (See Andy Martin’s excellent book, DollorLogic for a very readable discussion on this.) To reduce the risk of losses, include a variety of non-correlating assets in the portfolio, so that if equities go down, the non-correlating assets should go up, and vice versa (ideally).

So the next time someone suggests that you avoid bonds because “rates are low,” remember that low rates don’t have to mean low return, and of course–as we’ve seen recently–low rates CAN go lower. (If you want to read more, I have written before about How to Time Interest Rates.)

This is What Political Risk Looks Like: Every time some commentator says that this time is different, it’s generally because they want to put a positive spin on things. Today, however, I’d like to point out that this time–at least in the muni market–is different, and I don’t mean that in a good way. For many years, investors could buy a bond and rely on the promise to pay made by the issuer. But over the last 8 years, investors have had to become more aware of political risk. Unfortunately, there is not a political risk rating to rely on–wouldn’t that be great if there was? Some bonds have a wide margin of safety, and some less so. The temptation for an issuer to decide not to pay goes up as financial stress accumulates–and in addition to annual budget challenges, demographic trends can powerful long-term drivers of economic stress (just as demographics may have been the driver behind boom times too). The current news about Puerto Rico is not a surprise, but it is a good reminder of what political risk looks like to a bond holder. Big Tom Callahan knew that a promise needed to be more than just words on a package. Evaluating the quality of a promise that has to last for the lifetime of a bond needs to be done carefully and with diligence, and repeated again and again over the holding period of the bond. (Investors and citizens should all read James Grant’s article in Time Magazine, The United States of Insolvency.)

Bond holders need to be clear-eyed about the potential for political risk when they loan money by investing in bonds. With more than 60,0000 issuers in the muni market, most borrowers are serious and diligent in how they manage their debt. But the precedents being set now will make it easier for the next issuer that feels forced to choose which of their promises to honor.

It is because of this that I have come to believe that many experienced investors should consider professional management for some or all of their municipal bond portfolio. It is my belief that the fundamental reason to use a professional investment manager is when the investor does not have the time or the necessary expertise to properly make those decisions themselves. As the risks have gone up, so too should the amount of time and energy that should be devoted to maintaining the portfolio. Click here to read more about planning, performance and process.

Market Context Updated: sorry for the gloom and doom, we should have May flowers, right? Long-term trends notwithstanding, life has to go on and money has to be put to work. Your summer vacation may be close, but never let a dollar sit around doing nothing. A dollar at rest tends to remain at rest, and a dollar at work tends to stay at work. If you have money lying around doing nothing that you need to put to work, click here for the weekly Muni Market in Context update.

Keep in mind that it is not possible to invest directly in an index. There are ETFs that seek to follow many of the fixed income indices  but their actual performance could vary from that of the index due to a variety of factors. 
The opinions expressed and the information contained herein are based on sources believed to be reliable, but accuracy or appropriateness is not guaranteed. Past performance is interesting but is not a guarantee of future results. The author does not provide investment, tax, legal or accounting advice–this is NOT investment advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Additional information available upon request.

May 2, 2016.

©2016 Patrick F. Luby. All rights reserved.

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