Is it time to be worried about municipal bonds, or have the recent negative headlines created a buying opportunity in this usually sleepy asset class?
Market participants appear divided. Muni bonds took a dive in 2010's fourth quarter owing to several factors: interest-rate jitters, supply and demand concerns, and, at least to some extent, worries over municipalities' financial health stoked by the bearish prognostications of financial analyst Meredith Whitney in a widely discussed 60 Minutes segment. More recently, however, munis have mounted a comeback, indicating that at least some investors must spot value there. For the one-month period through Feb. 23, the typical muni-national fund in Morningstar's database had gained 1.7%, while the average high-yield muni offering had gained nearly 2.0% in that same one-month period--pretty big numbers in this usually slow-moving asset class.
Morningstar users appear to be similarly bifurcated over the future direction of munis, based on your responses to my recent query on the Investing During Retirement forum of Morningstar.com's Discuss boards. While some users are content to stand pat or even add to their municipal bonds at this time, others feel that the many unknowns in the municipal market warrant a more guarded tack. Click here to read the complete thread.
Not Time to Panic
Of the users who posted, the majority noted that the recent news flow regarding municipalities hadn't deterred them from sticking it out with tax-free bonds and bond funds.
Reti59 summed up that sentiment in this post: "I'm not jittery. I like the tax-exempt dividends too much."
Pinky3 is also satisfied to watch and wait. "I am not doing a thing; just holding and compounding tax-free." Jackie wrote, "The compounding is very enjoyable to watch. If I need to tap into the dividends for extra income, I will. For now, I am letting the fund grow."
Nupnup11 is another investor who's standing pat despite some recent turbulence in individual muni holdings. "Approximately 10.0% of my portfolio is in tax-free munis. Those that expire in the near term have increased in value. Those that expire beyond 2020 have lost approximately 6.0%. Average interest 5.3%. My portfolio is all taxable and not used for retirement. I'll just hang on to it unless I really need the cash."
Rkay48 acknowledges that the recent headlines have been unsettling but isn't inclined to cut back on the asset class. "Yes, all the negative hype has made me more nervous. But I hold, one, individual bonds, nearly all AAA or AA; I'm not selling any of these. And two, short-term muni funds: Vanguard Limited-Term Tax-Exempt (VMLTX) and Fidelity Short-Intermediate Muni Income (FSTFX); I'm not selling these either."
Relative to some of the analysts who have recently been weighing in on the muni market, Bitsotree likes the research that professional muni-fund managers bring to the table. "Who is Meredith Whitney anyway? What are her credentials? Maybe she's correct but she fails to provide evidence. Janet Tavakoli shined a bright light on Whitney's lack of credibility. Tavakoli is miles ahead of the TV personalities in terms of intelligence. So are the people who manage municipal bond funds. These managers have more than enough intelligence and experience to avoid pitfalls that exist in the municipal bond market. I prefer to ignore the talking heads and continue to have faith in the folks at Fidelity and Baird who manage my municipal bond funds."
Carman, too, would like to see the pundits face greater accountability: "Because market prognostications are a dime a dozen and seem to contribute a lot to market instability, it would be interesting to see a system implemented to rate the forecasters on the accuracy of their predictions by adding or subtracting stars based on the outcome of their predictions over a fixed (three- or five-year) period. I don't expect that anyone in the analyst community wants to hear this, but a lot of us less sophisticated investors take expert predictions with a grain of salt the size of a small cow lick."
Capecod is similarly disparaging about the prognosticators and thinks the recent headlines have created a buying opportunity for astute investors: "The folks charged with filling airtime and column inches to attract eyeballs to ads have learned that fear sells best. Bank analyst Whitney and outstanding mortgage-backed securities trader Jeffrey Gundlach have gotten lots of attention for themselves and their new firms. However, the considered views of municipal finance- specialist credit analysts and portfolio managers with decades of muni experience and success receive almost no attention. After all, reiterating that AA-ish, geographically diversified muni portfolios, managed by experienced credit analysts and PMs, exhibit superior creditworthiness and offer outstanding risk-adjusted returns is simply no longer exciting enough to count as financial news or to grab those eyeballs for the ads. So, like Gundlach, if you read his words rather than just the headlines, I anticipate there'll be some chi-chi in muni-land as these outstanding assets pass from weak frightened hands into strong ones--as hedge funds and institutional investors exploit a once-in-a-generation investment opportunity."
Holiday has been one of those buyers, writing, "I loaded up on muni's last November. I bought more in January." Windmill3900 also enthused about values in the muni market. "We've been buying individual bond issues for three months. There are great buys if you can find them."
Poster $unshine, a seller of munis seven months ago, has been scooping them up recently, even for tax-advantaged accounts. "I purchased selected closed-end funds during the frenzy following the Whitney report. I have even purchased some close-end funds for my IRA, as the rate of return is higher and safer than REITs."
Win1177 also plans to start buying but will move in slowly. "I had built up a sizable cash position with dividends, interest, and savings, but I am now going to start putting $5,000 per month into muni funds. I don't need the income yet, it will be for retirement. So I'm letting them compound. I will slowly build my bond allocation up from about 15% now to 30%-40% over next five years. It's impossible to time it just right as far as going back into munis, so I'm just [dollar-cost averaging] back in as I get new money."
FidlStx is also eyeing munis: "I'm looking hard at munis right now. I think the scary news has driven away the fearful, leaving an investment niche that offers a nice buffer against other scary news, like north-African strongmen falling like pennies standing on edge. Sure, the risks are real, but I think prices are compelling, and regular interest payments offer a nice buffer to a spread-out portfolio. I plan to buy into a muni exchange-traded fund/closed-end fund in the next three months."
Poster PRESSmUP concurs, noting that what's trash for some is treasure for others. "I'm not nearly smart enough to exit (or enter) any specific class of assets on a wholesale basis. My dollar-cost averaging strategy is to steer new money into asset classes against the grain of popular opinion--the theory being that the retail investor makes the precisely incorrect decision at the most inappropriate time. As long as these transactions don't throw the basic portfolio allocations completely overboard, this highly unscientific method of where to direct new money has worked pretty well over the past few years. So yes, I am adding to munis."
Time for Repositioning
While not necessarily putting new money to work with both fists, some users noted they've been repositioning their muni holdings amid the volatility.
Petrus1949 wrote, "After having moved down the yield curve in November, I'm beginning to feel confident about moving back out a bit. I still think there are some choppy waters ahead, but nothing that alarms me."
Yogibearbull is of a similar mind. "I have been shifting from short-term to intermediate-term munis on weakness. I understand the possible risks (headlines, defaults) but with munis trading at or above Treasury rates, and some even competing with corporates, enough compensating spread is there. And I can buy more if the spreads go up even more."
Win1177 is also feeling ready to take a little more risk in munis. "I had been steering any new money primarily to Vanguard Limited-Term Tax-Free up until now. However, I am soon going to send any new money to the intermediate/high-yield funds."
Weberjg, meanwhile, is standing pat with some of his shorter-duration holdings. "I live in Virginia, so I have a considerable amount in USAA VA Bond (USVAX). When the price went to $1.00 below my average cost, I began to add shares. My other muni exposures are all through Vanguard. Last Nov. 15 I sold all of my long-, intermediate-, and limited-term holdings at a long-term profit. My remaining holdings are all very short duration."
Poster Harry6 has been sticking with the asset class but diversifying geographically. "I'm a buy-and -hold type and avoid interest-rate risk by buying actual bonds. I've recently been adding AAA state general obligation bonds, diversifying out of my state of residence. At this point, I believe we have short-term headline risk and long-term pension/benefit risk to manage. Most municipalities have a pretty good track record at managing budgets and debt but need to demonstrate the ability to deal with the pension/benefit issues in the longer term. Under any circumstances, going forward, doing your homework on the issuing municipality is critical."
Users varied in their views of whether it's preferable to hold individual bonds or bond funds at this juncture. Saltydog wrote, "I buy individual Treasuries and tax-exempts in a single state and ladder them over 10-12 years. I've moved tax-exempts down from about two thirds to one half. The tax-exempts are primarily AAA and AA with a few A. I will replace maturing tax-exempts if there is a spread over Treasuries. I think the odds of a few headline grabbing defaults are pretty good. However, the chance of a default affecting the portfolio as described is quite small. On the other hand, bond funds could take big hits because of panic selling, rising rates, inefficient markets, unrated holdings and leverage. I would avoid bond funds."
Win1177 is feeling more comfortable with professional management: "As far as individual bonds, I hold five different South Carolina state bonds (where I live) and there are some really juicy yields available, but I'm holding off for now. I think the folks at Vanguard are probably better at individual credit analysis than I am. Once I see the economy in this area turning up more, and the state budget situation improve, I may buy some individual bonds--primarily GO or good revenue/sewer/water bonds. I definitely would not go below BBB+ and probably would stay at single A minimum. But not right now, I prefer the broader diversification of a fund, I'd hate to have a $25,000-plus bond just suddenly stop paying! Painful! Although in reality the odds of that are very low (at least historically)."
Although a number of users still have faith in the muni market, other users find all the uncertainty to be uncomfortable.
Econ101 eloquently opined: "What is worrisome is the level of unknown risk in municipal bonds. No less an authority than Arthur Levitt, the former chairman of the SEC, has been critical of the disclosure levels of most municipal bond obligations. In 46 out of the 50 states, pension funds have been underfunded for years, and equity returns over the past 10 years have fallen woefully short of assumptions of long-run returns. Meanwhile, Congress is tinkering with the bankruptcy code for states as quietly as it can. Moreover, if the subprime mess taught anything, it's to carefully evaluate the frequencies inherent in the underlying probability distributions, which may be quite dissimilar to those in the past due to systemic changes. Perhaps it's best to compare the default risk the market is pricing into rates and assess the risks that way. Though I could use the tax-sheltered income, I won't commit capital where the risks are so ill-defined for limited returns."
Ramble165 agrees that the relatively modest level of historic defaults in the muni market doesn't foretell the future. "Pundits aside, I am very concerned with the increasing power of public-sector unions to destroy state and local governments' ability to manage within their budgets. Unions seem only to want to elect those who will spend more money the states don't have with no regard for the citizens they supposedly are hired to serve. End result will be states in bankruptcy and increasing levels of bond defaults. Maybe Meredith isn't as crazy as some think."
BR4777 is worried about public pensions' effect on municipalities' financial health, noting that poor disclosure makes it very difficult for muni investors to get their arms around the breadth of this issue. "There is an ongoing problem with risk that is unmeasurable at present. The Unfunded Actuarial Accrued Liability of public pensions are a huge problem because, generally, most public agencies (and I have worked in them) do not have anyone on board who either knows enough about how to go about paying it down or cares about anything but their pension and so pushes it off on the next 'servant.' The inherent issue is that the UAAL does not have to go on the balance sheet as a liability. That needs to change. The public has the right to know what the specific long-term and cash-flow liabilities are for any public entity--not just some pooled state-level forecast. One cannot determine the relative riskiness of just about any muni bond without this information.
"The question is: Will this huge problem in pensions affect the ability to pay muni bonds? It depends on what you think the future will hold. Until the public pension obligations are clearly identified per issuer, there will always be more risk in muni bonds that is on the surface."
Yogibearbull offered his own prescription for shoring up the public pension system, including better disclosure and no pension-funding holidays. (Read the complete thread for Yogi's always well-considered views.)
ThinkSnow worries that even relatively modest levels of bad news in the muni market could have a contagion effect. "The sentiment is ready for bad news and will multiply bad news by a factor of three. A small spark could set major panic selling. What happens if Mudville has its worst day since Mighty Casey stuck out in 1888 and misses a payment on the town's water treatment plant? Will it be the spark in the gunpowder magazine? Will all water-treatment plants having similar rating to Mudville drop by 12% over the next week? Will other towns in the same county as Mudville see panic sales? The total number of defaults could be small, but the effect on the net asset value of municipal bond funds could be huge. A decline in interest rates may not save us this time."
Rather than feeling pessimistic about munis specifically, Darwinian argues that all bond investors should keep their expectations in check in the face of potentially rising interest rates. "As the panic wears off, there may be some modest price appreciation. I don't expect a return to the unusual price levels of last fall, however. It must be remembered that we are moving into an environment of rising interest rates, and all bond classes are going to struggle just to maintain prices."
Not Waiting Around to Find Out
Given the uncertainty in the muni market, at least a few users indicated that they'd been selling. GusPass wrote, "We sold our muni fund in the middle of last year at a small profit. It constituted about one fourth of our portfolio and had been uncharacteristically volatile since 2008. The hype aside, it's not a good time to be in munis, too much questionable debt and uncertainty everywhere."
W004dal also thinks the asset class' risks outweigh the benefits. "I got out of munis over a year ago--before that fire was fully stoked. Munis are still a valuable part of a portfolio--especially for income seekers--but should play a much more limited role than they used to."
At this juncture, poster cjger is comfortable trading munis for corporate bonds. "I sold T. Rowe Price Tax-Free High Yield (PRFHX) and bought T. Rowe Price Strategic Income (PRSNX) (corporate bonds). My thinking was that the high-yield aspect increased risk, though I am confident enough in Price funds not to expect crashes. Corporate bonds just make me feel safer."
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