Income Investor Perspectives

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
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