Notes on the Current State of the Muni Bond Market
by Annette Thau
Are you worried about your bonds (or your bond funds)?
The fixed-income markets are currently getting very bad press. No less an oracle than Warren Buffett recently dubbed bonds “instruments of mass destruction.” The perception that risk is high is primarily due to the fact that interest rates remain at historic lows. The consensus seems to be that interest rates can only go up and this creates interest rate risk: When interest rates rise, the price of a bond (or a bond fund) declines. The extent of the decline is directly related to maturity length. The other face of interest rate risk, of course, is that when interest rates decline, the price of bonds rises. Again, the extent of the increase is tied directly to maturity length.
In this article
- The Municipal Bond Market: 2010–2012
- How Safe Are Municipal Bonds?
- Buying Individual Bonds in the Current Environment
- When Does Paying a Premium Make Sense?
- Municipal Bond Funds
- Investing in Closed-End Municipal Bond Funds
- Should You Invest New Money in Bonds or Bond Funds?
- Junk Bonds
- U.S. Treasuries
- Conclusion
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Interest rate risk affects all fixed-income securities, including Treasuries. Discussions of interest rates and interest rate risk all start with Treasury bonds. More precisely, these discussions focus on the bellwether 10-year Treasury bond, since interest rates in other sectors of the bond market typically follow Treasury rates, either up or down. If interest rates rise on Treasuries, so will those of municipal and corporate bonds.
A second factor for the current bond market worries is the constant drumbeat about the shaky finances of bond issuers—in other words, concerns about credit quality. Perception of credit risk differs for different sectors of the bond market and varies over time. Treasuries are deemed to have the highest degree of safety. Municipal bonds are next. The credit quality of corporate bonds varies widely but, on the whole, it is not nearly as high as that of municipals. Approximately 50% of all corporate bonds are now rated below investment grade—these comprise the so-called high-yield, or “junk,” bond sector.
This article focuses on the municipal bond (“muni”) market. It discusses to what extent current concerns seem justified, and it makes some suggestions about how to handle both bond funds and individual bonds.
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Discussion
Annette,
I wonder if you are underestimating the political risk of municipal bonds. For example, what happens when the market is no longer willing to buy the debt of either Illinos or California? Do you think the politicians will choose to continue to service existing debt at the expense of state pensions and retiree health care benefits, or will they stiff "rich" bond holders seeking tax exempt income in favor continuing pension and health care benfits to hard-working Americans?
Thanks.
Jim
posted 10 months ago by James from Illinois
A couple of comments about the box on closed end bond funds. Another reason for holding this type of security is unrestrained liquidity. Many open ended bond funds (eg Vanguard) have frequent trading and liquidation limits that may effect one's ability to liquidate positions in down markets. Looking and the bond fund duration data will give a index of interest rate volatility. Finally many closed end funds sell at either a discount or premium for long periods. Buying a fund at a discount to NAV does not necessarily mean that it is a bargain. Looking at pricing history is a better way to figure this out.
posted 10 months ago by William from Florida
First, interest rates are at historical lows manipulated by the FEDs. This is not the time to buy bonds. Second the muni market has not changed in 50 years; the spread in 3 percent. Dont try to sell a bond, you may get a low ball bid from an un-named source who is actually your own broker. Ratings are meaningless and can change overnight by several ranks. Insurance, regulated by the NY Insurance commissioner is a fraud. Small bond buyers over the last decade have been screwed by the banks, brokers and insurance companies. Speciffically, we were sold INSURED securities in a market unregulated to control insurance company default and fraud. Yet Wall Street continues to rake in the big bucks and sidesteps regulation attempts.
posted 10 months ago by John from California
Given the assumptions listed, how long would interest payments have to be reinvested in a muni bond fund for the investor to get back to par after a 1% riase in intrest rates?
Assumptions: Duration of 7 years, an expense rations of .25% and a return of 3.8% of tax-exempt income
posted 10 months ago by Will from Massachusetts
Being a holder of a municipal bond fund, I feel comfortable after
reading your article
posted 10 months ago by Patricia from New York
This is an excellent example of clear financial writing. Thoughtful and measured, it is valuable for long time muni investors while being accessible to newcomers. Thank you Ms. Thau and AAII.
posted 10 months ago by Alan from New Jersey
In evaluating closed end funds its also important to make sure that the fund is earning at least as much as it is distributing and that there are unused revenues (UNII) for problem periods. Cefconnect.com has all the info you need to select muni cefs that are paying upwards of 5% tax free.
posted 10 months ago by Douglas from Arizona
Enjoyed the article and thanks.... Any reason why I would need to diversify my individual bonds among more than one bond shop? I am presently using Stoever Glass in NYC. As you know, they recommend and buy the bonds for me and also hold the bonds. It is a little scary not actually having a bond as proof of purchase but I am told that that is the way it is done today. I do get confirmation statements and monthly statements.
Sound kosher to you ?
Thanks again.
posted 10 months ago by Pete from New Jersey
this article is the most informative presentation of bond, bond funds and munis i have ever read.exellent and honest descriptions of bond market.thank you.
posted 10 months ago by Asghar from Connecticut
"Yield to Worst" is not as comforting as it sounds. It does not, according to my experience, take into account sinking fund redemptions scheduled prior to maturity. Such sinking fund redemptions apparently are not considered "calls" as selecting non-callable only securities does not eliminate bonds with sinking fund redemption schedules and likewise such are not considered a 'call' when yield to worst is posted.
posted 10 months ago by Larry from California
Wasn't Warren Buffett referring specifically to derivatives as "instruments of mass destruction". (cf, "derivatives are financial weapons of mass destruction", Berkshire Hathaway 2002 Annual Report, p.15)
posted 10 months ago by Fred from California
I did not see any referance to the fact that any premium paid for tax exempt is not considered a loss for tax purposes.
posted 7 months ago by Joseph Turney from Kansas
When are the muni bond professionals and bond buyers going to realize that yield to maturity, yield to call or yield to worst do not accurately reflect the yield on a muni bond? For example, if someone buys a bond maturing in 2030, with a 5% coupon and a YTM of 4%, they are not rally earning 4%/year. The YTM, YTC, YTW calculations assumes that the 5% coupon is invested at 4%, which is not likely. I have developed a more accuarte fomula for determing the yield on a bond. While munis still offer a good investment it's a real eye opener to calculate the "true" yields.
posted 5 months ago by S Frank from Connecticut
