Income Investor Perspectives

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
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