Advice & Dissent

Jack Calhoun | Principal

Examining the common (non)sense that causes investors to fail.

Muni Bond Mayhem, Or Just Another Version of "A Nightmare on Main Street"?

February 2011

One of the most painful things about my line of work is watching the investing public commit one grievous mistake after another and being unable to do anything about it. I can help my clients avoid the emotional, reactionary missteps that are so tempting in times of turmoil, but there is nothing I can do for the masses who seem predestined (hey, I’m a good Presbyterian) to destroy themselves in every conceivable market cycle. No matter what the situation, the majority of investors do the wrong thing every time. It’s like being forced to watch a horror movie in slow motion, over and over and over again…

So, as I look at the recent happenings in the municipal bond market, all I can think is: “Here comes A Nightmare on Main Street, Part 214.”

First, for some context, here is a brief review of the average American investor (we’ll call him “John Q. Public”) and his experience over the past 15 years:

• In the late 1990s, John Q. Public loaded up on technology stocks, especially “dot-com” stocks. When the bubble burst in the spring of 2000, he lost about 80% of his investable assets.

• After the tech bubble burst, Mr. Public took whatever funds he had left and fled to the “safety” of cash investments. And he did indeed feel safe there for awhile, until the market suddenly took off in the spring of 2003, gaining 50% in 12 months while he earned 1% in money-market funds.

• In the mid-2000s, Mr. Public then tiptoed back into the risk pool, but he was still wary of stocks from his frightening experience in the 2000-03 bear market. So he split the difference and went mostly into bonds, just in time for interest rates to go up, which caused his bonds to fall in value. He lost money here, too.

• With the stock market back to record highs by 2007, John Q. Public realized what a fool he had been. The recovery was complete and all was safe with stocks! And, oh, what returns those financial and real estate stocks had delivered! He loaded up on rock-solid banks and financial service companies. Then the subprime financial crisis hit. The Dow fell nearly 60% over the next two years, and many financial stocks went under entirely. By early 2009, Mr. Public was once again completely fed up with “losing money in stocks” and went back to cash, locking in catastrophic losses.

• Right on cue, the market enjoyed its strongest gain in 80 years. From its March 2009 low, the Dow gained 90% in 18 months, but Mr. Public missed it. By late 2009 – fed up with making literally nothing in cash – John Q. Public went, not to those risky old stocks, but back to bonds. Safe, secure bonds. Except the safe, secure bonds weren’t delivering returns much higher than cash. So Mr. Public went searching for “yield”, moving farther out on the yield curve and lower down in credit quality. He invested in the supposed safety of municipal bonds, but opted for the higher-yielding, longer-term variety – never stopping to wonder why those bonds were producing such high yields in a low interest-rate environment.

And that brings us, inevitably, to today’s “muni bond crisis” that has been heavily touted in the headlines. Last fall, famed analyst Meredith Whitney issued a dire forecast for municipal bonds, and small investors panicked en masse. Municipal bond funds were swamped with redemption requests, forcing many of the funds to dump their bonds on the market at discounted prices to raise cash. That created a huge glut of bonds on the open market, and prices dropped accordingly.

Most experts believe that the muni bond market overall remains extremely secure. In a report last month, ratings agency Standard & Poors noted, “We believe the crises that many state and local administrators find themselves in are policy crises, rather than questions of governments' continued ability to exist and function… (The crises) are more about tough decisions than potential defaults." (See: Standard & Poor's, U.S. States and Municipalities Face Crises More of Policy Than Debt.)

S&P went on to say in the report that, for significant defaults to occur, state and local governments would have to face revenue declines roughly double to what they were during the Great Depression – an unlikely scenario to say the least.

Unfortunately, small investors have not grasped this reality and are selling muni bonds without regard to risk or return. That has forced yields higher because new issues coming to market must be competitive with the existing issues being sold at fire-sale prices on the secondary market. And that, in turn, has sent prices lower for all existing muni bonds.

What is lost on most investors is that municipal bonds come in almost as many flavors as Baskin Robbins’ ice cream. Consider this: While there are only about 8,500 publicly traded stocks in the U.S., there are millions of municipal bond issues in a wide variety of structures. There are general obligation bonds, revenue bonds, pre-refunded bonds, insured bonds, taxable muni bonds, escrowed-to-maturity bonds, and many others. The type of bond, the maturity of the bond, and the credit worthiness of the issuing municipality all play heavily into the risk and return characteristics of the bond.

Not surprisingly, therefore, the selloff in the muni market has not impacted all bond prices the same. Muni bonds of high credit quality, and with short- to intermediate-term maturities, have not been much impacted by the so-called crisis. Many of these are general obligation bonds, backed by the taxing authority of the municipality and insured against default. Some even have “pre-refunded” features in which Treasury Bills have been escrowed to ensure that the principal is there to be repaid when due.

The spread in performance between these types of bonds and the lesser quality, longer term bonds that enticed small investors with their higher yields has been eye-popping. For example, while the Pimco High Yield Muni Bond fund declined a whopping 9% from mid-November to mid-January, the DFA Short-Term Muni Bond fund only declined about 1%.

Unfortunately, most individual investors once again succumbed to return chasing and followed their quest for yield out to the edges of the yield curve, ending up in high-yield funds that they have now sold for 10% losses, or, worse individual issues like 30-year munis that have sold for losses of 20% to 30%. It has been a jarring realization for these folks that “safe and secure” bonds can be as volatile as stocks – perhaps even more so – if you are in the wrong bonds at the wrong time.

Alas, all of this pain could have been avoided if the investing public had subscribed to our philosophy about fixed income at Capital Directions: “Bonds are a risk-reducer – not a return-juicer.”

In other words, if you want “return”, let stocks do that for you. If you want “stability”, let short- to intermediate-term, high quality bonds do that for you. And never get those two objectives confused.

If only John Q. Public could get the memo…

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