This week in the Muni Catchup:

• Fiduciary, Munis & You
• Should All Munis Be Taxable? Part 2
• Redemptions
• Wisdom from Buffett
• Summer Reminder
• The Bottom Line

Fiduciary, Munis & You

Because most investors do not buy munis in their tax-deferred retirement accounts, municipal bond market participants may not have been paying close attention to the new Department of Labor fiduciary rule, which applies only to retirement accounts. However, a recent article in Investment News shows that the Department of Labor has been paying attention to the muni market, as shown by a recent clarification to the rule:

Originally, firms acting as principals would have been prohibited from directly purchasing and selling muni bonds from or into a client’s retirement account. The April version of the rule was changed to allow principals, which hold muni bond inventories, to purchase bonds from clients, essentially expanding the market of potential buyers of the bonds.

This is good for investors. The DOL clearly recognized that, particularly in times of market stress, there is no logical upside to limiting the universe of potential buyers of a security that an investor wants to sell.

However, for some reason, the DOL seems to be holding firm, for the time being, on not allowing principals to sell muni bonds out of its inventory to clients investing through their individual retirement accounts.

Jeff Benjamin, DOL fiduciary rule gets it half right on the municipal bond market. InvestmentNews, July 7, 2016.

This would seem to be irrelevant to the muni market because munis are rarely purchased in tax-deferred accounts. In practical terms, though, it is relevant for taxable munis (such as Build America Bonds), because they often offer higher yields than are available on comparably rated corporate bonds–making them attractive for purchase in retirement accounts.

Because the rule will disrupt how dealers will be able to re-distribute the bonds purchased from retirement accounts, the current equilibrium in the already illiquid taxable muni market may be upset, forcing yields (and yield spreads) higher to offset the reduction in potential demand.

Taking advantage of those higher yields may be more difficult, though, because of the coming changes in how market makers will be able to transact with retirement accounts. Rather than buying individual bonds, however, financial advisors and investors may find it easier to buy and manage their allocation to taxable munis by using mutual funds or ETFs.

Investors with tax-exempt portfolios, such as endowments and foundations, may an even more attractive opportunity since they will retain the ability to transact directly with the market makers.

Footnote: InvestmentNews has a page dedicated to their coverage of the DOL fiduciary rule.

Should All Munis Be Taxable? Part 2

As I explained in my special Catchup last week, it is not me asking that question, but it is the topic of a new research report published last week by The Tax Foundation. In addition to what I wrote last week, I had one more thought to share:

• If Congress did move to reduce or eliminate the tax exempt status of munis, would that also prompt a move by the states to seek the ability to tax interest income from U.S. Government and Agency bonds?

You may also wish to read this article from Bloomberg about the potential for increased political risk to the tax-exemption from a narrowing investor base.

Redemptions

Yes, Christmas is just five months away, but right now it is DEFINITELY still summer. The forecast high for today in my town was 99 degrees…which, as you can see, is hotter than another well-known place…

Meanwhile, in the air-conditioned comfort of the muni market, it is still Summer Redemption Season, which will conclude in August as an estimated $30.1 billion in redemptions will flow back to investors.

At current rates, many advisors and investors are be uncertain about how to reinvest–or even if they will want to reinvest in municipal bonds.

In addition to all of the factors that should normally be considered (issuer, credit rating, coupon rate, maturity date, call features, par amount, etc.), the decline in secondary market liquidity and the increase in political risk need to be managed more carefully than ever.  See The Bottom Line, below, for my current thinking.

The Wisdom of Buffett

There are only a few more weeks of summer, which means only a few more installments in my “Wisdom from Buffett” series. It is especially in summer when I find that his insights and stories really resonate with me, but his timeless wisdom transcends seasons and appeals to young and old alike. I have always been impressed by how well he is able to express himself, which is why–as my family knows–I simply refer to him as The Poet.

This week’s quote:

When I woke up this morning
I was tired as I could be
I think I was counting my money
When I should have been counting sheep

From Makin’ Music for Money, by Jimmy Buffett

Summer Reminder

What are you reading this summer?

To help you “digest” what you read this summer, be sure to also spend some time with The Summer Thinking List. This year’s edition is already my all-time most viewed post.
There are separate versions for advisors and investors, but don’t wait! Once Labor Day gets here, the lists will be taken down and put away until next summer.

The Bottom Line

Check Your Calls: Older callable bonds that are valued at a premium are at an increased risk of being called away–just as the reinvestment options have become less attractive. This doesn’t mean that you should sell callable bond holdings, but it does mean that you should only add additional callable premium bonds after evaluating the concentration of call risk in your portfolio. It would also be sensible to evaluate what you would do if your callable bonds were called at their next call date.

Beware the Coupon: Favoring par bonds now may not be a prudent move for investors because of the potential exposure to the unfavorable tax treatment on market discount should rates move higher. If you are a buyer, continue to favor premium bonds–to reduce the risk of bonds moving to a discount if rates move higher.

Pay Attention to Duration, but Don’t Be Afraid of It: As uncertainty clears and some of the recent global flows into bonds reverses, higher duration bonds and indices will be expected to underperform the rest of the bond market. So while it may be tempting to put new money to work where performance has been the strongest (in long-duration bonds, funds or ETFs), we all know that past performance is not an indicator of future returns. When the market turns, duration will be the total return investor’s foe. Unless you are an active total-return investor prepared to react quickly to market changes, new money should be put to work in line with the long-term goals as defined by your investment policy statement. But don’t be afraid of duration…it is possible to be too short on the yield curve. My discussion of duration in this article also applies to mutual fund and bond selection.

Don’t Forget Taxable Munis! Investors with money in tax-deferred or other non-taxable accounts should compare the yields on taxable muni bond offerings versus comparably rated corporate bonds. But as I noted above (in Fiduciary, Munis & You), it is now time to be paying attention to how you buy taxable munis–especially in tax-deferred retirement accounts.

Thanks for reading! Let me know if you have any questions and have a great week.
Pat

This is not investment advice. 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. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Indices are not available for direct investment, although in some cases, there may be ETFs available designed to track some of the indices shown. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Additional information available upon request.
©2016 Patrick F. Luby
All Rights Reserved

Should Muni Bond Interest Be Taxable?

That is the question asked in a new research report published today by The Tax Foundation.

Here are a few quotes from the paper, with my editorial comments:

The strongest economic justification for the tax exemption of municipal bonds is that it encourages state and local governments to invest in infrastructure projects that create benefits for nonresidents. On the other hand, there is also reason to believe that the tax exemption will cause municipalities to overinvest in infrastructure, particularly if states and localities are also able to shift their tax burdens onto nonresidents. (Key Findings, page 1)

My comment: “will cause municipalities to overinvest in infrastructure”? Really? It seems that a constant reality in our country is the absolute need for more investment in infrastructure: water and sewer systems, bridges, roads, tunnels, airports, etc., etc., etc. And by the way, if there is “over investment,” then by definition, those projects would be uneconomic and unable to service the debt. The market has been very efficient at recognizing non-economic bond issues (also known as non-investment grade, or speculative).

Most importantly, there is a compelling case that the current tax treatment of municipal bond interest is inefficient. For every dollar that the federal government forgoes due to the provision, state and local governments receive less than a dollar in lower borrowing costs; the remainder goes largely to high-income households. (Key Findings, page 1.)

Inefficient? Proposing that financings of local projects should be routed through Washington D.C. seems to create a much greater likelihood of inefficiency. Wasn’t it temporary tax incentives created by Congress that started Puerto Rico down the path to insolvency? If you were not familiar with that, see Adventures in Muniland, by Comes, Kotok and Mousseau. (The book is on my all-season recommended list.) I quote from their chapter on Puerto Rico:

In 2006, tax policy changes removed certain incentives for businesses to locate production in the Commonwealth. Assessing their options, companies began to relocate, taking jobs with them. (Page 198.)

Federal tax policy created the artificial (i.e., non-market driven) demand for locating jobs in Puerto Rico–that’s ok as a policy, but it can be destructive when policies are changed. As jobs moved into Puerto Rico, money was borrowed to finance needed infrastructure that became unsupportable after the tax incentive was changed and jobs moved away from the island. (THIS is an example of “encouraging overinvestment in infrastructure,” and it started in Washington.) I could go on, and I have in the past, so if you’d like more on this part of the topic, see my short essay, The Reverse Midas Effect.

Voters love to hear politicians talk about tax-simplification. Replacing the tax exemption of munis with a Federal tax credit sounds to me like tax complexification (sorry if that is not a word, but it sure should be).

I know, I’m a “muni guy,” so I’m biased. But I am also a citizen, taxpayer, voter and father. I have a vested interest in efficient government not only now, but for the decades ahead. Low cost financing for essential and sustainable governmental infrastructure projects increases the ability to complete needed projects. Muni bonds have being filling that need for well over a hundred years. (And by the way, why is it that any dollar not collected by the Federal government is considered “forgone tax revenue”?)

So should muni bond investors be worried? It is impossible to handicap what could happen to the tax exemption if the new Congress and new President decide to re-work the tax code. But there is some margin of safety right now in that in many cases, muni yields are higher than taxable yields. I encourage you to read the report and form your own opinions. I’ll delve more into the relative yields in next week’s complete Catchup.

Thanks for reading! Let me know if you have any questions and have a great weekend.

Pat

PS–You can subscribe below to get my updates e-mailed to you as soon as they are published.

This is not investment advice. 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. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Indices are not available for direct investment, although in some cases, there may be ETFs available designed to track some of the indices shown. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Additional information available upon request.
©2016 Patrick F. Luby
All Rights Reserved

Muni Catchup 7/18

• Time Travel
• Bonds Are Still Worth Owning
• Brave New Transparent World
• The Wisdom of Buffett
• Reminder
• The Bottom Line
• PS

Time Travel

Last week, the bond market traveled back in time, but only by a couple of weeks.

Despite giving back some of the rally that had moved many yields to historically low levels, in many cases yields remain at levels lower than just a month ago. Last week’s jump up in yields suggests at least a partial reversal of the Brexit-induced flight to safety and liquidity. (If you haven’t already read it, be sure to see my comments last week about the dangers of liquidity.)

While yields are not as painfully and historically low as they have been recently, they are still very low (see the Yield Trend Table for details), as money has continued to flow into the bond market. According to The Investment Company Institute, over the last five weeks, equity market mutual funds and ETFs have lost a combined $12.7 billion in assets, while bond funds and ETFs have added $18.9 billion. ($10.9 billion to taxable bonds and $7.9 billion to muni bonds.)

Interestingly, for the week ended July 6, muni ETFs attracted a much larger share of the inflows than they have recently–suggesting that an increased number of investors wanted to take advantage of the exchange-traded flexibility of ETFs.

Data from FactSet Research Systems, Inc. shows that the week ended July 13 also had positive flows into muni ETFs, although at a slower pace than the week before. (The heavy inflows in the week ended July 6 were likely driven at least in part by the heavy July 1 muni redemption activity.) For more details on flows, please see Municipal Bond Fund Flows on the Context page.

Cash market trading has remained steady–year to date, daily trading volume has averaged $10.1 billion, with June averaging $12.3 billion a day. Month to date, July has been averaging $9.2 billion per day, with last week averaging $10.8 billion per day.

“Bonds Are Still Worth Owning”

There are a few must-read books for investors, and there are a few must-read commentators. One of those commentators is Jason Zweig of The Wall Street Journal (and author of several books as well as an excellent website). In his column from Saturday the 16th (here’s the link for subscribers) he writes:

The generation-long bull market in bonds is probably drawing to a close. But high-quality bonds are still the safest way to counteract the risk of holding stocks, as this year’s returns for both assets have shown. Even at today’s emaciated yields, bonds are still worth owning.

His point in the article is to remind investors to look at the real yield on bonds, that is, the yield after adjusting for inflation. He argues that even with low nominal yields, the real (“after inflation”) yields on a historical basis “are not as wretched an investment as they seem.” (How’s that for an endorsement!) Certainly, if looking just at U.S. Treasury yields, no one is going to get excited. (Although it is worth keeping in mind that yields have gone down because of demand.)

I would add, though, that there are other sectors of the bond market that offer higher yields than Treasuries without taking on an inordinate amount of incremental credit or duration risk. The municipal bond market is one of those sectors, and is attractively priced versus Treasuries. (See this week’s Market in Context.) My thoughts on positioning can be found below in The Bottom Line.

While “Conventional Wisdom,” as Zweig writes, is that “there’s never been a worse time to invest in government and corporate debt,” investors should pay at least as much attention to where money is flowing as they do to “conventional wisdom.” And money has been flowing into bonds, not out.

For individual investors seeking to pursue a specific goal, cash flow remains the best antidote for uncertainty, and diversification is the best antidote for volatility. Bonds solve for both of those goals.

I’ve written about this before, but I’ll write it again: Let your goals determine your allocation to bonds. Let the market influence which bonds you buy.

Brave New (Transparent) World

A new GASB (Governmental Accounting Standards Board) standard will add clarity to currently under-reported state and local government liabilities. GASB 75 regarding disclosure of “Other Post-Employment Benefits”, also referred to as OPEBs, is effective for fiscal years beginning after June 15,2017, but the Board encourages earlier adoption.

This change is important because as municipal bond issuers adjust to the new reporting standards, their reported liabilities may change.

A recent example comes from the city of Chicago. As reported by Greg Hinz in Crain’s Chicago Business, ” the city’s reported net liabilities more than tripled last year, soaring to a stunning $23.8 billion.” He notes that the city’s liability hasn’t actually increased by much, but that the city is moving to the newer more transparent reporting standard.

The increased transparency resulting from this change is welcome news for the market and investors (as well as for taxpayers).

Muni bond investors who do their own credit research should familiarize themselves with the new GASB 75 standard and be prepared to dig deeper than the headlines as issuers begin reporting their liabilities according to the new standards, which have to potential to affect perceived credit risk and, in some cases, ratings as well.

The Wisdom of Buffett

As I noted before, for the summer, I have added a new weekly feature in the Muni Catchup, “Wisdom from Buffett.” His insights and stories about how he has approached life have endeared him to his fans. And, because his timeless wisdom appeals to young and old alike, he seems to be more influential and popular than ever. I have always been impressed by how well he is able to express himself, which is why–as my family knows–I simply refer to him as The Poet.

This week’s quote:

The wrong thing is the right thing until you lose control

From The Bank of Bad Habits, by Jimmy Buffett

Investment application: choose “the right thing” at the beginning so that you don’t have to make a change when the market is volatile.

Footnote: Click here if you’re looking for more suggestions about wisdom and poetry.

Reminder

Are you reading something special this summer? To help you “digest” what you read this summer, be sure to also spend some time with The Summer Thinking List. This year’s edition is already my all-time most viewed post. If you haven’t gotten started on it yet, you still have plenty of summer left! There are separate versions for advisors and investors, and in fact, the investor version closes by suggesting that readers “Make an appointment now to meet with your Advisor after Labor Day to review this list.”

Don’t wait! Once Labor Day gets here, the lists will be taken down and put away until next summer.

The Bottom Line

Check Your Calls: Older callable bonds that are valued at a premium are at an increased risk of being called away–just as the reinvestment options have become less attractive. This doesn’t mean that you should sell callable bond holdings, but it does mean that you should only add additional callable premium bonds after evaluating the concentration of call risk in your portfolio. It would also be sensible to evaluate what you would do if your callable bonds were called at their next call date.

Beware the Coupon: While the 5% coupon has been the favored structure for issuers (and institutional investors) for many years, the relentless decline in rates means that dollar prices have also marched higher and higher to the point that in many cases they have gotten uncomfortably high even for some professional investors. Favoring par bonds now may not be a prudent move for investors, though, because of the potential exposure to the unfavorable tax treatment on market discount should rates move higher. Except for a small exclusion, the market discount realized on the sale of municipal bonds is subject to taxation at the holder’s ordinary income tax rate–not the capital gains rate. So if rates move higher and today’s par bonds are sold at a discount in the future, subsequent bidders will lower their bid prices to make up for the more onerous taxation of the market discount that would have to be paid by the subsequent holder. If you are a buyer, beware of the coupon rate (and the dollar price) on new purchases. Continue to favor premium bonds–to reduce the risk of bonds moving to a discount if rates move higher.

Pay Attention to Duration, but Don’t Be Afraid of It: As uncertainty clears and some of the recent flows into bonds reverses, higher duration bonds and indices will be expected to underperform the rest of the bond market. So while it may be tempting to put new money to work where performance has been the strongest (in long-duration bonds, funds or ETFs), we all know that past performance is not an indicator of future returns. When the market turns, duration will be the total return investor’s foe. Unless you are an active total-return investor prepared to react quickly to market changes, new money should be put to work in line with the long-term goals as defined by your investment policy statement. But don’t be afraid of duration…it is possible to be too short on the yield curve. My discussion of duration in this article on ETF.com also applies to mutual fund and bond selection.

Don’t Forget Taxable Munis! Investors with money in tax-deferred or other non-taxable accounts should compare the yields on taxable muni bond offerings versus comparably rated corporate bonds.

Thanks for reading! Let me know if you have any questions and have a great week.

Pat

PS–to make my site more reader friendly, I have reorganized my material into three categories: About Investing, About Life and About Me. If you have comments on the new layout or suggestions for new articles, please let me know.

This is not investment advice. 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. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Indices are not available for direct investment, although in some cases, there may be ETFs available designed to track some of the indices shown. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Additional information available upon request.
©2016 Patrick F. Luby
All Rights Reserved

Beware of Liquidity!

Right now, greater liquidity might actually mean greater risk.

Have you been wondering why so many investors are willing to accept negative yields on bonds?

Ever since the 2008 financial crisis, the bond market (and particularly the U.S. Treasury market) has served as a safe haven for investors seeking a liquid place to put their money while waiting for a more favorable “risk on” investing environment.

In the wake of the Brexit vote, the volume of assets moving into the safe harbor of bonds appears to have accelerated, as shown by the dramatic worldwide decline in yields. For investors seeking temporary refuge in the bond market, liquidity is often much more important than income or diversification. Additionally, for investors seeking to reduce their exposure to a declining currency, even at negative yields, bonds denominated in a foreign currency could ultimately provide a positive total return when converted back into the home currency. 

That means that investors whose primary goals are income or diversification are bidding against investors for whom price (or yield) is no object. (Or almost no object.) This is especially so in the most liquid parts of the bond market. There are several concerns arising from this:

• The parts of the bond market that are most liquid hold the greatest appeal for investors seeking safe haven. Because of the recent volume of buying, it means that all investors have to accept the lower yield in order to buy–even if liquidity is of lesser importance than income or diversification.
• When the flows reverse, yields could move higher just as quickly as they have declined–moving prices lower just as quickly too. In addition, due to the reduced liquidity in the bond market, prices could decline even more quickly than they have gone up. (Please see my earlier comments about Muni Market Liquidity in the June 10 Muni Catchup.)

The Asset Class Formerly Known as Safe

Recent volatility in bond yields and prices may be jarring to investors, but it doesn’t mean that bonds are no longer “safe.” (Whatever that means!) Credit strength and margin of safety are not affected by increased buying demand, but lower yields do make it more difficult to recover from a bond investment that has to be sold at a loss, making the process leading to a buy (or hold) decision to be even more critical than ever.

The most important take-away from the last two weeks should be that asset allocation and diversification still work. As my friend Andy Martin writes in his book DollarLogic, “Most stories about investors ruined in the market are stories about lack of diversification.” I wholeheartedly agree with his observation that “It is often better to reduce risk than it is to increase return.” And, I would suggest, that is exactly what we are seeing right now in the bond markets as investors around the world are willing to forgo yield in order to reduce risk.

While muni bonds have traditionally held less appeal to non-U.S. investors, that is changing. As more non-traditional investors seek temporary shelter in the muni market, they will look first at the most liquid parts of the market.

This does not mean that traditional muni investors should be avoiding the market but rather should be mindful of how much they are paying to be in a sector with greater liquidity and more appeal to non-traditional investors. Patient investors with a long-term horizon may be better off by looking at sectors of the muni market that do not have sufficient size or liquidity to attract non-traditional investors. The hard part, of course, is balancing liquidity (or lack thereof) against yield, credit risk and other factors.

• Investors in individual bonds may wish to consider looking at smaller issuers or structures (coupon rates, maturities, call features, etc.) that are slightly out of favor. Investors who have been active primarily in the new issue market may find more attractively priced offerings in the secondary market.
• Investors considering muni ETFs should pay attention to recent money flows to identify spikes in flows that may indicate non-traditional buyers coming in.
• Don’t forget muni bond Closed End Funds. Because of the small denominations, it is a retail driven but notoriously illiquid market and may offer attractive incremental yields. But beware! Muni closed end funds can trade at significant discounts to their Net Asset Value. (Also worth considering is the Van Eck ETF that invests in a basket of muni closed end funds. See this article for more thoughts about selecting a muni ETF.)
• Investors uncomfortable with making these decisions may wish to consider a professionally managed active strategy such as an open-end mutual funds, a separately managed account (SMA) or even an ETF strategist.

The Wisdom of Buffett

As I noted before, for the summer, I have added a new weekly feature in the Muni Catchup, “Wisdom from Buffett.” His insights and stories about how he has approached life have endeared him to his fans. And, because his timeless wisdom appeals to young and old alike, he seems to be more influential and popular than ever. I have always been impressed by how well he is able to express himself, which is why–as my family knows–I simply refer to him as The Poet.

From “I Used to Have Money One Time,” by Jimmy Buffett:

I made a deal with the devil for a whole lot of money
Thinkin’ it would last and last
But a fool and his money are bound to part
And what goes up must come down
So take my advice, don’t trust the roll of the dice
Keep your feet on solid ground

Application: leave the speculating for the speculators. Investors should be investing for the long term.

Muni Bond Redemptions

Bonds mature, creating the opportunity or headache of reinvesting the returned principal. As you should hopefully be fully aware by now, the months of June, July and August are the heaviest months for muni bond redemptions. (Because most issuers use a fiscal year that ends on June 30.) So even though it may be inconvenient or unappealing to deal with right now, investors with bonds maturing must confront the decision of how to put the matured principal to work. While it may be tempting to think that the low rate environment means that you are not giving up much by waiting, the resulting under-diversification could seriously undermine your long-term goals. Please take a page from the professional portfolio manager’s handbook, and let your goals drive your asset allocation. Market conditions should influence which bonds you buy–not whether or not you buy bonds. Here are the details about Summer Redemption Season.

The Market

You’ve already printed out this week’s Muni Market Yields in Context page, right? If not, then go print it out to hang next to your workstation for the week. Keep that and local new issue scales handy to keep up with what’s going on in the market.

Month-to-date (and year-to-date), duration is still the investor’s friend (as of close, July 8), as shown by the strong performance of the 20-Year High Grade Bond Index. The only indices with higher total returns were taxable muni indices and the Muni Tobacco Bond Index.

Click here to browse through all of S&P Dow Jones’ 206 municipal market indices.

Reminder

The Summer Thinking List for 2016 is out and is already my all-time most viewed post. If you haven’t gotten started on it yet, you still have plenty of summer left! There are separate versions for advisors and investors.

The Bottom Line

In addition to my concern about being cautious about investing in the most liquid parts of the muni market, I stand by my closing thoughts from last week’s Catchup:

Check Your Calls: Older callable bonds that are valued at a premium are at an increased risk of being called away–just as the reinvestment options have become less attractive. This doesn’t mean that you should sell callable bond holdings, but it does mean that you should only add additional callable premium bonds after evaluating the concentration of call risk in your portfolio. It would also be sensible to evaluate what you would do if your callable bonds were called at their next call date.

Beware the Coupon: While the 5% coupon has been the favored structure for issuers (and institutional investors) for many years, the relentless decline in rates means that dollar prices have also marched higher and higher to the point that in many cases they have gotten uncomfortably high even for some professional investors. Favoring par bonds now may not be a prudent move for investors, though, because of the potential exposure to the unfavorable tax treatment on market discount should rates move higher. Except for a small exclusion, the market discount realized on the sale of municipal bonds is subject to taxation at the holder’s ordinary income tax rate–not the capital gains rate. So if rates move higher and today’s par bonds are sold at a discount in the future, subsequent bidders will lower their bid prices to make up for the more onerous taxation of the market discount that would have to be paid by the subsequent holder. If you are a buyer, beware of the coupon rate (and the dollar price) on new purchases. Continue to favor premium bonds–to reduce the risk of bonds moving to a discount if rates move higher.

Pay Attention to Duration: As uncertainty clears and some of the recent flows into bonds reverses, higher duration bonds and indices will be expected to underperform the rest of the bond market. So while it may be tempting to put new money to work where performance has been the strongest (in long-duration bonds, funds or ETFs), we all know that past performance is not an indicator of future returns. When the market turns, duration will be the total return investor’s foe. Unless you are an active total-return investor prepared to react quickly to market changes, new money should be put to work in line with the long-term goals as defined by your investment policy statement.

Thanks for reading! Let me know if you have any questions and have a great week.

Pat

This is not investment advice. 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. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Indices are not available for direct investment, although in some cases, there may be ETFs available designed to track some of the indices shown. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Additional information available upon request.
©2016 Patrick F. Luby
All Rights Reserved

Q2: Duration Was the Bond Investor’s Friend

Some of the total returns earned this year in the bond market are the envy of equity investors. Generally speaking, duration was the winner, as shown by the select indices shown below, the higher the duration–the higher the total return. While buy and hold investors are less concerned about total return (as they tend to be long-term investors, rather than tactical asset allocators), they will likely be excited to see the quarter-end values of their existing holdings to be much higher because of the decline in rates.

Q3: Check Your Calls & Beware the Coupon

One of the quirks of the municipal bond market is that unlike the U.S. Treasury market, there is not a comprehensive standard yield curve that can truly represent trading activity. This is not for a lack of effort, as there are in fact some excellent benchmark yield curves to describe the muni market.

However, since most muni CUSIPs don’t trade on a regular basis (in a typical quarter, over 95% of all muni CUSIPs don’t trade at all, according to recent MSRB data), writing a curve every day requires interpolations and extrapolations based on actual trading data and assumptions–such as what kind of coupon rate (par or premium), call structure, general market or specialty state, ratings, etc. The assumptions will vary according to what the benchmark is used for. As a result, depending on whom you ask, you may hear that the MMD scale is the best, or MMA, or Bloomberg, or another scale.

Above: the Bloomberg 30-year muni spot yield closed June 30 at 2.176%, down from 2.657% on 3/31.

No matter which benchmark yield curve you look at, however, muni yields in the second quarter dropped by a lot, and at the longer end of the yield curve, they dropped by more than U.S. Treasury yields. (See the Yield Trend Table.)

In addition to the seasonal demand driven by the heavy Summer Redemption Season, there seems to be an increase in the long-term trend (sometimes referred to as secular trend) of money flowing into munis. As shown on my Municipal Bond Fund Flows table, the year to date flows into mutual funds and ETFs is much heavier than in the last two years.The cause is difficult to know with certainty, but intuitively the trend makes sense as retiring and retired baby boomers need to replace their earned income with investment income, and even at low yields, munis do generate a reliable fixed amount of income until maturity.

The Bottom Line for Q3:

Check Your Calls: So, what’s my takeaway about all this? Because of the dramatic decline in muni yields, the arithmetic of refinancing older munis has gotten better for issuers (whose interests are opposed to investors). In other words, older callable bonds that are valued at a premium are at an increased risk of being called away–just as the reinvestment options have become less attractive.

While this doesn’t mean that you should sell callable bond holdings, it does mean that you should only add additional callable premium bonds after evaluating the concentration of call risk in your portfolio. It would also be sensible to evaluate what you would do if your callable bonds were called at their next call date.

Beware the Coupon: While the 5% coupon has been the favored structure for issuers (and institutional investors) for many years, the relentless decline in rates means that dollar prices have also marched higher and higher to the point that in many cases they have gotten uncomfortably high even for some professional investors. Favoring par bonds now may not be a prudent move for investors, though, because of the potential exposure to the unfavorable tax treatment on market discount should rates move higher. Except for a small exclusion, the market discount realized on the sale of municipal bonds is subject to taxation at the holder’s ordinary income tax rate–not the capital gains rate. So if rates move higher and today’s par bonds are sold at a discount in the future, subsequent bidders will lower their bid prices to make up for the more onerous taxation of the market discount that would have to be paid by the subsequent holder. If you are a buyer, beware of the coupon rate (and the dollar price) on new purchases.  Continue to favor premium bonds–to reduce the risk of bonds moving to a discount if rates move higher.

Pay Attention to Duration: As uncertainty clears and some of the recent flows into bonds reverses, higher duration bonds and indices will be expected to underperform the rest of the bond market. So while it may be tempting to put new money to work where performance has been the strongest (in long-duration bonds, funds or ETFs), we all know that past performance is not an indicator of future returns. When the market turns, duration will be the total return investor’s foe. Unless you are an active total-return investor prepared to react quickly to market changes, new money should be put to work in line with the long-term goals as defined by your investment policy statement.

Puerto Rico: You all know what’s going on with Puerto Rico, so I will spare you any additional discussion, but do see Caveat Emptor in the June 27 Muni Catchup if you haven’t read it already, and visit Bloomberg.com for the up-to-the-minute news.

I’ll be back on Tuesday with the next regularly scheduled edition of The Muni Catchup. Best wishes for a safe and fun Independence Day holiday.

Thanks for reading,

Pat

PS–When was the last time you sat down and read our country’s founding document? Independence Day is a good time to do that. One old friend is in the habit of reading it out loud for his family and friends before the traditional dinner of hamburgers and hot dogs is served. Do you have a similar tradition? Maybe it is time to start one.

When, in the course of human events, it becomes necessary for one people to dissolve the political bonds which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the laws of nature and of nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable rights, that among these are life, liberty and the pursuit of happiness. That to secure these rights, governments are instituted among men, deriving their just powers from the consent of the governed. That whenever any form of government becomes destructive to these ends, it is the right of the people to alter or to abolish it, and to institute new government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their safety and happiness.

Click here for a 2-page PDF of the Declaration of Independence.

PPS–Have you printed out The Summer Thinking Lists for yourself and your clients? Come on, don’t make me come down there and print them for you!

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. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Indices are not available for direct investment, although in some cases, there may be ETFs available designed to track some of the indices shown. 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. Additional information available upon request.

©2016 Patrick F. Luby
All Rights Reserved