John Spence had an article run on Marketwatch over the weekend weighing the pluses and minuses of municipal bonds and municipal bond ETFs. A few days ago Matt Hougan wrote a favorable piece on the PowerShares Build America Bond ETF (BAB). Over the weekend the Barron's cover story was about the current state of the states. Mike Shedlock writes prolifically about current economic events in the states. Read all of this, if you haven't already.
The big macro is that many states are in a lot of trouble. Per the Barron's article, called The $2 Trillion Hole, 46 states have underfunded pensions although I should note that a few of the states are only off by a slight amount. You probably also know that 48 states (South Dakota and Montana the two exceptions the last time I looked) have budget deficits.
If employment does not improve then the states will collect less in the way of income tax, if home prices continue to go down then the states will collect less in the way of property tax and if all of this impedes consumer spending (not an unreasonable conclusion) then states will collect less in the way of sales tax. This all serves to seriously threaten the revenue structures of the states.
Then layer on the pension issues and consider that weaker states have to pay more to borrow which only worsens the situation. Regardless of how you think this part of the story will work out it is clearly a mess right now. About a year ago I mentioned getting out of California munis for any client who had them. A couple of readers left comments sort of disagreeing, in the belief that one way or another things would be ok. I don't buy much in the way of munis but some folks had them from before we managed the accounts.
You may know from past posts I am not a big fan of taking risk in the fixed income portion of the portfolio and to the extent we take a little risk, taking risk in treasuries or munis is absolutely not the trade we want to make. I don't want to be the one that has to figure out how this works out with client money on the line. There are plenty of quality corporates that are at very low risk of failing and quite a few foreign sovereigns at very low risk of failing; lower risk than the states anyway. With all the stats about the trouble the states are in if a state does fail how would you, as an advisor explain, to a client why you owned the paper? If they do fail then everyone will say how obvious it was that they were going to fail. I think it makes sense for advisors and do-it-yourselfers to just avoid the space altogether.
If you have to be in the municipal space then maybe the Market Vectors Pre-Refunded ETF (PRB) could be a buy but to be clear we do not own it.
As the Marketwatch article alluded to, investors are seeking yield and so might be willing to take more risk. This may be true but short term relatively safe paper has a yield in the ones; we are in a 1% world. If you buy a 4% yield you are taking risk and I am quite certain that there are many people, including advisors, who do not fully understand the risk that they are taking.
On a different note I am thrilled that the NCAA Tourney is about to start. The 64/65 game in on ESPN tomorrow at 7:30 east/4:30 west. I will say however that I really dislike all references to the event that contain any form of the word dance. And is it me or is Clark Kellogg awful?
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22 comments:
1: I concur on the "dance" comment to the ncaa. Where in the world did that even come from. I half expect to start hearing references to wins as "pining the corsage on that one" and referring to MVPs as the "prom queen".
2: If its one thing I have picked up from here its "I don't want to worry about being wrong." In looking at most muni funds they were heaviest in the states having the most problems. I no longer see the point of taking a 4%ish yield from struggling governments for my fixed income portion when there are other areas like emerging market debt that have a higher yield with younger populations growing and expanding their economic base. IMO I think the risk to yield ratios here are reversed. I bailed on my muni position last month.
Going for higher yield bonds to produce greater income rarely makes sense whether it is munis or something else.
Dickie V. drives me nuts. Fortunately, John Madden retired so I don't have to mute NFL football anymore.
As for munis, I have a small position in BAB and will continue to hold it for now as part of a diversified portfolio. The important thing, in my view, is not to overdo any segment of the bond market in much the same way that you practice segment weighting for equities.
Clark Kellogg is annoying and I'm not sure how he's the #1 color guy.
Illinois certainly has a massive budget problem, and NO ONE will talk about lowering pension/benefit obligations for future state employees.
Our upcoming gubernatorial choices are really great: current lame duck Democrat who wants to raise taxes and avoid all talk of 1) cutting expenses and 2) how raising taxes fixes 25% or 33% of the problem vs. guy who talks cutting expenses, but is turning out to be kind of a wackjob who's more concerned about some puppy farm bill.
I'm still have positions in short-term, high quality muni's but have been out of the longer duration issues for over a year: Early as usual but I passed the point of better safe than sorry in my strategic accounts a couple decades ago so no biggie. The credit crisis was so big and bad it is still being revealed like an onion, a layer at a time.
Slightly OT (but not too much), Simon Johnson provides one of the most coherent explanations of the financial crisis I've seen at http://vimeo.com/9953346 (8 min)
The title of the talk is a bit over the top but Johnson's work is empirical rather than theoretical -- he's looking right at the main financial data trends and calling them out by name -- and that is a distinct virtue; it would be any time but even more so now given the overheated political climate we live in.
"...I am quite certain that there are many people, including advisors, who do not fully understand the risk that they are taking." And the impication is that you do have a firm understanding.
So what is it that you believe will happen? Widespread defaults? What exactly are the risks that many others do not fully understand? I would like to know since I am heavily invested in munis.
You correctly point out states' budget troubles, but fail to point out that most are not simply burying their heads in the sand. Just this weekend the paper reports Arizona is permanently slashing $3M from its budget (as a percentage of the total budget it is huge). A few weeks ago, the governor of CO announced that he was cutting pension benefits. Many muni bonds are issued by local governments who are not experiencing difficulties. Flipping through my annual and semi annual reports, there are almost no bonds issued by "states" per se. In most cases, the law requires bond holders be paid before anyone else, including salaries.
I wholeheartedly agree that someone who purchases individual bonds should excercise great caution. On the other hand, I have been to an event where the manager of USAA muni mutual funds presented information that was quite reassuring. There has to be some trust somewhere or our whole society breaks down. I'm placing trust in Vanguard and USAA.
During the great correlation, the NAVs of my mutual funds dropped somewhat. They recovered nicely in six months or so. The cash flow never faltered. Some leveraged CEFs dropped more than 50% and have not recovered. I suppose it is all in the type of muni risk you want to take. I guess I think of my mutual funds as "your grandfathers' oldsmobile." Not much excitement.
IMO, the currency risk from emerging market debt far outweighs widespread muni default. "I don't want to worry about being wrong." Exchange rates are even more difficult to predict than interest rates. What are you gonna do then after the fact?
Rhianni32 Being wrong in conversation is just fine but this problem with the states seems like it could be so obvious that I do want to avoid being wrong w/client money on the things that are so obvious.
anon 6:02 I used to dislike Dick Vitale but at some point (many years ago) I realized that his enthusiasm is 100% genuine.
SD Illinois seems to really be in a jam. If it is anywhere near as corrupt as my wife's family says then I don't know how it ever fixes itself.
thank you for the link RW.
WH I know the risk only in as much as I know it is not worth taking--this is the entire point i am making. the risk in the muni market is way beyond what has been normal in my time in the business. As I do not think of munis and treasuries as risk assets it makes sense to me to simply avoid assets like these when the risks are abnormally high.
What do I believe will happen? To reiterate I am not willing to bet client money that I will be correct about what will happen.
oh and I don't have any emerging market debt.
as far as currencies being less predictable the current risk/reward dynamic of the muni market is not normal relative to itself.
the currency market risk/reward dynamic is normal relative to itself IMO
I still don't know what specific risks you refer to. Bonds generally have these risks: interest rate, credit quality (default), call, systemic, and liquidity among others.
Can you give specific examples of, "the current risk/reward dynamic of the muni market is not normal relative to itself." I simply cannot understand what you are saying here. It seems vague and generalized to me.
Rhianni32 seemed to imply emerging market debt is less risky than high quality muni debt, even in light of currency flucuations. I find that fascinating.
FWIW, specifics help me in understanding concepts rather than gross generalizations. I am here to learn.
i outlined what i perceive as the issues that states have and provided links to sources with more detailed information.
Annette Thau's "The Bond Book" is one of those I wish I had known about in my earlier investing years: Thorough, practical and profitable; one of the best in the bond “what and how to” genre IMHO.
Even those who prefer investing in bond funds could benefit (you'll know a lot more about assessing their portfolio and management acumen) but it may also help you graduate to designing your own portfolio.
i don't know that book--hopping over to Amazon TY
I like Larry Swedroe's "The Only Guide to a Winning Bond Strategy You'll Ever Need." Very readable, no complex mathematics.
IMO, it is hard to beat Vanguard's expense ratio of .12% for Admiral shares compared to trying to build a laddered portfolio.
Swedroe does a good job of presenting both cases.
I got a few more replies than I thought so perhaps I should expand...
Anon 5:53: I don't limit my fixed income or dividend equity selection solely on yield.
WH: Yes at this time I think emerging market debt is more secure then U.S. municipals.
For the US we have an aging population, baby boomer problem (social secutiry and medicare), and a government that is unwilling to cut spending for risk of being voted out. As has been mentioned elsewhere, they want to kick the can down the road to be a problem for someone else. Some of the above problems are at a federal level and we are talking about munis. However with a bogged down federal government they are less likely to give bailouts to states at the levels the states want or need.
In contrast we have emerging markets that have a younger populaton, gaining wealth, and looking to grow. China is the exception with their 1 child per family rule but since they dont offer debt that I have found its not pertent to this topic. The investing community talks a lot about how emerging markets are the places to be equity wise. Well if these countries are expanding and growing wont they need infrastructure? Roger has talked about that being a theme with emerging market infrustructure ETFs. As an extension I believe that those governments will need to sell bonds to pay the companies in the ETFs to build things.
If and when state governments make the tough choices I'll return to munis. As a form of discloure while I am 0% weighted in munis I am only 3% in emerging market debt. If I am totally wrong about this then I can live with the consequences.
Thanks to all for the book mentions. I've been wanting some reading on bonds.
I still don't know what specific risks you refer to. Bonds generally have these risks: interest rate, credit quality (default), call, systemic, and liquidity among others.
Can you give specific examples of, "the current risk/reward dynamic of the muni market is not normal relative to itself." I simply cannot understand what you are saying here.
Political risk? The risk that governments at all levels: federal, state, municipality change the rules of the game in the middle of the game. I would think one lesson of the 2008 credit crisis is when the fit hits the shan, and it comes down to a question of the “needs” of workers, citizens, pensioners, etc. versus the “rights” of holders of financial assets, the latter will get screwed. After all, they are just “greedy, wealthy” speculators living off the “blood, sweat, and toil” of the common man. Witness the Obama administration response to the automaker situation (don’t recall if it was Chrysler or GM bonds).
In most cases, the law requires bond holders be paid before anyone else, including salaries.
Do we live in a country right now where the “rule of law” supersedes everything else or can the rule of law be trumped by special interests or even voters? When it is a question of substantial reductions to teacher or police salaries, or pension benefits, or paying bondholders there contractual interest payments who comes out victorious? I just don’t know, but I can see why as Roger points out it is simply a risk not worth taking.
A political comment, here. Mike C's observations are so true and, even more than the hard-line left wing agenda, are my number 1 complaints with the Obama-Pelosi-Reid administration. The thing that separates us from just another 3rd world state is that contracts are in-violable. With the GM-Chrysler/UAW bale outs, Obama-Pelosi-Reid violated centuries of bankruptcy law and handed a political payoff to the unions (and Obama is supposed to be the number 1 law enforcement officer in the country). Given the GM-Chrysler shenanigans, the outrageous way the dem's are ramming the health care bill through is totally not surprising; back room deals and gov't corruption at its worst.
"contracts are in-violable"
Hahah. Ok, that's funny. And it's not just 'cause I've been hitting up the high alcohol beer at Rock Bottom.
Stephen Drone must be a lawyer. They get rich going both directions until -- read the book "Animal Farm".
I used to be a big fan of muni's but right now I'm afraid, big time for all the reasons Roger mentioned. Maybe GM is 'too big to fail' but I doubt LA has the same political weight.
I'm more sanguine about the fate of muni's overall: Most issues will be okay, GO's and revenue bonds too at least where they were used to build income producing infrastructure, and the rising cost of additional credit will likely prevent a number of municipalities from refunding (forcing them to cut services instead) so the supply of bonds will probably shrink and, following the simple but powerful logic of supply and demand, the prices of remaining bonds will rise or at least hold steady.
I prefer to stay short-term for now but fully anticipate some trading opportunities and, later, some very good quality higher-interest issues hitting the markets at a good price.
OT: Thought WH would be all over the political comment since the, um, bias was so clear. Ah well, guess it could be mentioned that Republicans did more than their share of "ramming through" when they were in charge -- e.g., http://tinyurl.com/ces66k -- but that's just a tu quoque argument and not the core issue which is overheated, hyperbolic rhetoric about vague enemies or sheer vapor; e.g., is their any evidence that contracts are being violated at a greater rate than before or that plans are afoot to do so?
Evidence meaning something stronger than fear, talking points or the febrile imaginations of the chattering class; in a word, the kind of evidence an investor might take seriously.
RW,
I have no comment because sadly, both parties behave badly while in power. And I have to agree with Mike C regarding political risk. On the otherhand, there are many powerful people of both political persuasions who have a lot of wealth tied up in munis who would resist crapping in their own nest. After tax returns and cash flow are important to me, so for now I really don't see too many reasonable alternatives to munis. Also, I agree with you in keeping durations short/intermediate and with your overall analysis which to me is a bit more pragmatic than some othe viewpoints.
If nothing else RW, in addition to making me think, you have done wonders for my vocabulary. I am rarely able to read your posts without a dictionary :)
tu quoque
febrile
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