Muni Catchup 8/29
by Pat Luby
- Using mutual funds and ETFs as a barometer, money continues to flow into the muni market–the year to date total is now close to $50 billion.
- Last week’s comments from Fed Chair Yellen and others means that Fed intentions are now less obfuscated. (Sorry, but I just can’t use the word “clear” as an adjective here.)
- Due to pre-holiday staffing levels, the unemployment rate number that will be announced on Friday will likely lead to an exaggerated reaction from the bond market, but investors (as opposed to traders) would likely be smart to let the number settle in to see how the markets react next week when most trading desks are back to full staffing levels.
- As I’ve mentioned before, September muni redemptions are expected to be well below those of August, and new issue volume typically picks up after Labor Day, so the muni market–which has performed well–may be poised for some weakness if new issue supply does indeed pick up.
Bloomberg Now Owns the Barclays Agg!
Last week, Bloomberg announced the acquisition of the Barclays Risk Analytics and Index Solutions Business.
The Barclays fixed income indices are now part of Bloomberg. This is relevant to every mutual fund, SMA, CEF or ETF manager and trustees or fiduciaries. It is even important and relevant to financial planners, as many planning and asset allocation programs use the Barclays Agg when calculating an appropriate exposure for fixed income. Having the historical index data available via the Bloomberg terminal could be really helpful.
Bloomberg also added a new web page for the current day’s data for those without a terminal.
Pensions & Transparency
There was an article last week on ZeroHedge.com that provided an excellent summary of some of the challenges that have to be confronted in Illinois. Similar challenges will have to be confronted elsewhere, of course.
From the perspective of a muni bond investor, it is crucial to understand what the future obligations of a bond issuer will be. In that regard, there is some good news: the Governmental Accounting Standards Board (GASB) has provided updated guidance regarding the accounting treatment of state and local government pensions (GASB 68, effective for fiscal years starting after June 15, 2014) and other post-employment benefits (GASB 75, effective for fiscal years beginning after June 15, 2017.) In both cases, GASB recommended earlier implementation if possible.
Unfortunately, the GASB Pronouncements do not address the discount rate for calculating the present value of future liabilities. An over-optimistic rate of return will result in a lower present liability–and, therefore, most likely less political fallout because it would reduce the apparent need to provide for increased funding at the present time. A lower and more realistic rate of return will result in a larger present liability–requiring an increase in funding and most likely in taxes as well. At the present time, there is some discretion in choosing the most appropriate discount rate to use for the actuarial calculations. With that discretion comes the opportunity for favoring short-term concerns at the expense of higher future costs.
These points are important to bond buyers because the margin of safety enjoyed by investors can be undermined if other financial obligations are allowed to grow to unsustainable levels.
If you want to dig deeper into the topic, here are a few more articles:
Muni NetGuide: This May Be One “Discount” That’s not So Appealing
SeekingAlpha: Beware Of Yields Too Good To Be True: Chicago Munis
Pensions & Investments: Actuarial leaders disband task force, object to paper on public plan liabilities
Puerto Rico’s pension woes are not typical, but show what can happen when a suffering economy combines with declining demographic trends and out-migration.
(Note: amazingly, all of these articles appeared in August. That suggests to me that there will be more coverage of this topic in the fall.)
What does this mean for muni investors? For self-directed investors, caveat emptor. If you are considering long-term general obligation bonds from an issuer with a lower pension funding ratio, consider what you think the trends will be over the lifetime of the bond that you are considering. Investors without the time or skills to conduct that kind of research and analysis should consider professional management. Revenue bonds with a specific and protected stream of revenue should be less exposed to the potential financial pressures of future pension funding demands, but in severe enough cases, if taxes have to be raised so much that it leads to out-migration, revenue bonds could suffer as well. At the very least, all of this points to the importance of the annual portfolio check-up to re-visit credit quality and trends.
Are you ready to squeeze everything that you need to get done this year into 83 days? Yup..there are only 83 business days between August 29 and Friday, December 30.
If you have not organized your objectives and tasks for the balance of the year, time is running out because next Tuesday, when you get back from Labor Day, you’ll be off to the races.
But don’t despair! The Summer Thinking List is designed to help you identify what you need to focus on. It’s not designed to sell you anything or to help you sell a particular product…it is designed to help you help yourself. But don’t wait! You don’t have much summer left, and the List will be taken down after Labor Day. Advisors can use the investor version to jump-start your client conversations.
THE WISDOM OF BUFFETT
His timeless wisdom transcends seasons and appeals to young and old alike, but it is is especially in summer when I find that his insights and stories really resonate with me. 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:
Headin’ up to San Francisco
for the Labor Day weekend show,
I’ve got my hush-puppies on,
I guess I never was meant for
glitter rock and roll.
And honey I didn’t know
that I’d be missin’ you so.
Come Monday It’ll be all right,
Come Monday I’ll be holding you tight.
Come Monday, by Jimmy Buffett
Here’s a link to a less than perfect video for the song, but it includes a fun explanatory intro from Jimmy. By the way, with Labor Day coming, it’s time to shift gears, so this will be the last installment of The Wisdom of Buffett. I hope that you’ve enjoyed them! If you need more Buffett, though, take a look at my Best of Buffett playlist.
- Oops! I realized that I had some mis-directed links on my “About Life” page, so the “Links of Note” is now working correctly.
- Look for a Special Edition of the Catchup late this week with some recaps of the market for August, with the next complete edition expected to be published on Tuesday.
THE BOTTOM LINE
Pay Attention to Call Risk & Extension Risk: Will the Fed raise rates? We’ll have to wait to see, but today’s low rates could go down, and you wouldn’t want to be forced to reinvest at even lower rates, so beware of how concentrated your call risk is–especially before you add any additional callable bonds to your portfolio. Also, do you have any bonds that are currently priced to a call but that would be at risk of getting priced to maturity if rates do go higher? If that happens, it could mean that you would then be subject to much higher interest rate risk because the duration for bonds is calculated based on the “priced to” date. This is what is referred to as extension risk, and investors should be on the lookout for it if rates do in fact begin to shift higher.
Beware the Coupon: All other things being equal, lower coupons mean higher duration and therefore higher interest rate sensitivity. Add in the unfavorable tax treatment of market discount on munis and investors who do not plan on holding bonds to maturity should be wary of buying par or discount bonds.
Don’t Forget Taxable Munis! Investors who do not need the tax exempt feature of munis should compare the yields on taxable muni bond offerings versus comparably rated corporate bonds. They can be hard to find, so if this makes sense for your situation, also consider a mutual fund of ETF.
Curve Positioning: Don’t pick a spot on the curve because of the yield, pick it because it adds the right risks to your portfolio. Pay attention to the duration (not just the maturity) whether you are looking at a bond, a fund or an ETF. The Context page provides some helpful numbers on the muni curve.
Credit Positioning: If the economy improves, rates would be expected to move higher and credit spreads would be expected to tighten. At the right price, taking on some credit risk might be ok, but it makes sense to favor the more liquid parts of the muni market, which generally means single-A rated or better. If you are tempted by the yields and returns in non-investment grade munis, exposure should be for only a minor portion of the fixed income allocation and should be professionally managed and broadly diversified.