Income Investor Perspectives

State Tax Revenues Decline

A new report on state tax revenues from The Nelson A. Rockefeller Institute of Government should raise credit concerns for muni bond investors.

State and local government taxes have continued a slowdown that began in the middle of 2015 and that has extended into the second quarter of 2016. State and local government revenue from major taxes tracked by the Census Bureau grew by 3.0 percent in the first quarter of 2016, the most recent quarter for which we have full details, which is a substantial slowing from the 5.4 percent average for the four previous quarters.

Total state tax revenue from all sources grew by 1.6 percent in the first quarter and preliminary data for the second quarter of 2016 indicate declines of 2.1 percent. The declines in state government tax revenues in the second quarter appear to have been driven by the weak stock market of 2015, and by slowing growth in sales tax and withholding collections.

The outlook for state budgets in the 2016-17 state fiscal year, which began on July 1st in forty-six states, remains gloomy.

State Revenue Report, September 2016.

Even though most local governments earn the bulk of their tax revenue from property taxes, state tax revenues are important both as an indicator of economic conditions and because of the dependence of so many local governments on state revenue sharing.

While these trends may not be a reason to take immediate action, they do bear watching–particularly for self-directed investors with exposure to issuers with a narrow margin of financial safety.

Have You Been Waiting on The Fed?

Hurry up and wait! Well, according to new data, muni investors have not been waiting on the Fed. In fact, individual investors have been adding exposure to munis. In case you missed it, please see my article on ETF.com or the special Catchup from 9/16.

The Dot Plot

Fed watchers were anxiously awaiting the pronouncement from last week’s FOMC meeting…in case you missed my comments, see my special Catchup 9/21.

The Bottom Line

Curve: Continue with a cautious stance as it pertains to maturity selection. Going out to 10-years picks up almost half of the available yield in the curve (see the Context page for details), but with much less risk. You don’t have to draw an artificial line in the sand right at ten years, but understand the duration risk of going longer out the curve.

Credit: It’s never a good idea to overload on any one source of risk, and credit risk gone bad can be especially painful to exit, but holding a modest amount of credit risk is reasonable given the current environment, and can add some incremental income as well as diversification. If you’re holding or are thinking about adding non-investment grade bonds, consider hiring a professional manager–either through an SMA, mutual fund or an ETF. (You saw my note above about the Rockefeller report, right?) Credit risk is often more correlated with equity risk than interest rate risk is, so overweighting your fixed income with credit risk may be reducing overall portfolio diversification. Be careful, and seek expert guidance if you need it.

Structure: Premium bonds remain favored for their lower duration and higher cash flow.

Calls: Don’t give away your call protection for free! Rates could go lower, so beware of the total call risk in your portfolio. There are attractive opportunities right now for short call “kicker” bonds that would have higher yields to maturity if they don’t get called–but be sure that you are well compensated for that extension risk. If you are going to accept call risk, be sure that you are getting paid to do so.

Products: muni bond mutual funds continue to have huge inflows. (Muni ETF flows have also been positive, but the dollar amounts are much less. See the Context page for recent data.) If those flows stop, that could take a lot of demand pressure out of the market, further pressuring muni prices, and if the flows reverse, even investors who remain in those funds could get hurt by fellow shareholders heading for the exits. For right now, though, the addition of two new muni bond ETFs from Van Eck is a good sign of demand and support for the market.

Have a great week, and thanks for reading. Please let me know if you have any questions.

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

Are You Smarter Than an FOMC’er? (Part 3)

FOMC day feels like Groundhog Day–the same thing, repeating over and over again, so I’m just going to update and repeat what I published before in my “FOMC’er” posts in Part 1 and Part 2.

Here it is! What everyone’s been waiting for! (Well, maybe not everybody.) The new Dot Plot:

The big takeaway for me is not whether we’ll see a rate hike this year, but rather the diversity of opinion about where rates will be.

As I’ve noted before, even the members of the FOMC are not of one opinion, with participant’s assessments for the end of this year ranging from .375% to 1.125%. (How about the end of 2019? The range is 5/8 to 3 3/4!)

Which opinion is correct? Are any of them correct? There are so many variables at work, forecasting rates with precision is not realistic.

Yes–it makes sense for traders, hedgers and many others to be concerned and focused on the short-term movements in rates. But for investors, trying to time rates means that you are likely exposing yourself to higher risk by not being properly diversified.

If you really want to accurately forecast rates, read my article on how to do it. Or, for a short-cut, ask The Magic 8-Ball. (If the answer is anything other than “Reply hazy, try again,” don’t rely on it.)

Income Investor Perspectives

by Pat Luby

September 21, 2016

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

Individual Ownership of Munis is Growing

New data from the Federal Reserve show that individual ownership of municipal bonds grew in the second quarter this year–but what is interesting is that the growth has been in professionally managed munis. While direct ownership of individual munis declined by $15 billion in Q2, it was offset by increases in ownership of muni mutual funds ($40 billion), closed-end funds ($2.5 billion) and ETFs ($2.1 billion).

Muni ownership even increased among non-U.S. buyers and non-muni bond mutual funds. See the Muni Catchup 9/16 for additional insight about the holders data.

Muni ETFs are Growing

With all of the challenges in the market and economic environments, it is not surprising that individual investors are putting more money into professionally managed solutions, both active and passive. Even with the recent market volatility, money has continued to flow into muni bond mutual funds and muni ETFs. (See the Context page for the weekly update.)

While ETFs represent only about 4% of the muni fund assets, they have been attracting about 10% of the net new asset flow. That out-sized share of asset flows helps explain why Van Eck will be launching two new muni ETFs this week:

• AMT-Free 6-8 Year Municipal Index ETF (ITMS). Estimated Duration 5.80
• AMT-Free 12-17 Year Municipal Index ETF (ITML). Estimated Duration 7.30

As a point of reference, based on current benchmark rates and assuming new purchases of all par bonds, a hypothetical 10-year laddered high-grade (double or triple “A” rated) portfolio right now would have an average weighted duration of 5.19 with an average yield to maturity of 1.23%

If you’ve missed them before, here are link to my thoughts about how to select a muni ETF or how to combine muni ETFs into an existing portfolio bonds, Part 1 and Part 2.

Risks are Growing

In “A Sour Surprise for Public Pensions,” The New York Times provides an excellent illustration of the financial challenges facing many public pension funds. This is an issue that is growing in awareness, and the longer that low rates depress pension fund portfolio earnings, the dollar size of the issue will grow as well. It is likely that the magnitude of some of the numbers involved will be affecting municipal credit ratings and market liquidity. In case you missed it, I encourage you to also read Pensions & Transparency in the Muni Catchup 8/29. Better managing the risks of exposure to issuers with significant pension underfunding is one of the benefits of using professional management for a muni portfolio.

Market Wisdom

Because of the growing risks to investors, this week I am going to quote myself (is that cheating?):

The fundamental reasons to use a professional investment manager are when the investor does not have the time or the necessary expertise to properly make those decisions themselves.

From The Benefits of Professional Management.

The Bottom Line

The consensus about when The Fed will raise rates seems to shift with the breeze, but one thing seems clear: when it happens, the yield curve is going to move, and the longer maturities could move by just as much–or more–than short maturities. Of course, longer bonds have higher durations and would therefore be at a higher risk of a decline in market value. In other words, maintain a caution stance as it pertains to maturity selection.

Curve: while there is an incremental pick-up by going out to about 15 years, the duration in that part of the curve can be around 12 or higher. While holding bonds to maturity can offset duration risk, for most, it may be prudent to focus on shorter durations. (Keep in mind that it is possible to be too short in duration–lower volatility will most likely also mean less diversification to offset equity risk.)

Credit: is the economy improving? If so, credit spreads should tighten, offsetting some of the price erosion caused by a potential increase in rates. It’s never a good idea to overload on any one source of risk, and credit risk gone bad can be especially painful to exit, but holding a modest amount of credit risk is reasonable given the current environment, and can add some incremental income as well as diversification. If you’re holding or are thinking about adding non-investment grade bonds, consider hiring a professional manager–either through an SMA, mutual fund or an ETF.

Structure: premium bonds should still be favored for their lower duration and higher cash flow. If rates do continue to tick higher, the higher cash flow will be available to reinvest at  the higher prevailing rates.

Calls: rates could go lower, so beware of the total call risk in your portfolio. There are attractive opportunities right now for short call “kicker” bonds that would have higher yields to maturity if they don’t get called–but be sure that you are well compensated for that extension risk.

Products: muni bond mutual funds continue to have huge inflows. (Muni ETF flows have also been positive, but the dollar amounts are much less. See the Context page for recent data.) If those flows stop, that could take a lot of demand pressure out of the market, further pressuring muni prices. If the flows reverse, even investors who remain in those funds could get hurt by fellow shareholders heading for the exits.

Have a great week, and thanks for reading. Please let me know if you have any questions.

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

Q: Are Munis Going Out of Style?

Direct ownership of individual municipal bonds went down in the second quarter, and is down for the year. Meanwhile, indirect ownership of munis through mutual funds, closed-end funds and ETFs grew. In fact, the growth in indirect ownership far exceeded the decline in direct ownership.

Municipal Securities: Household Direct and Indirect Ownership

Source: Federal Reserve, September 16, 2016. Dollar amounts in billions.

In the first half of the year, money market mutual fund holdings of munis declined by $52 billion–an amount that is not surprising given the pending changes with money market funds. (If you need a refresher on the reform, the ICI has a nice summary available here.)

While the municipal bond market is still dominated by individual investors, the relative value of munis continued to attract other buyers as well, as insurance companies added $7.4 billion in munis and banks added over $25 billion.

Even non-muni bond mutual funds were buyers of munis in the first half, adding $9.1 billion in munis. Foreign buyers added $2.2 billion to their munis holdings.

Liquidity

Looking at the amount of financial assets reported by broker-dealers as a proxy for their market-making activities (and therefore the depth of markets) reveals how liquidity for munis has declined over the last several years.

Since it peaked in 2006, broker/dealer support of the municipal bond market has declined by 61%. While there has been a recent uptick in support, as shown in the graph below, most longtime muni market participants are familiar with how much more difficult it can be to trade out-of-favor bonds. By using mutual funds or ETFs, however, investors are able to access liquidity through different and more predictable processes, perhaps explaining some of the growth in the flow into muni funds.

A: No.

Munis are not going out of style. Even with the recent decrease in ownership, direct ownership of individual muni bonds clearly remains very popular. In addition, there has been a large and growing appetite for  professionally managed munis in mutual funds, closed-end funds and ETFs. (See the Context page for additional information about recent muni bond mutual funds and ETFs flows.)

Income Investor Perspectives

by Pat Luby

September 16, 2016

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

Ugly is a Strong Word — Part 2

It was a painful day in the bond market (5-day chart of the U.S. Treasury 10-year note is below), so I’m just posting this in case you missed my article yesterday on Seeking Alpha, because it’s even more relevant now than it was yesterday.

Click here to read How Does A Bond Investor Get Defensive.

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