The debate over the reliability of municipal bonds (munis) continues to flood the media as several reporters claim the likelihood of these bonds defaulting due to rising state and local debt. On the other hand, some media outlets are claiming munis are still the most dependable investment available in today’s volatile economy. Plus, with consistent reports on how financially unprepared Americans are to handle their money in a difficult market, we find ourselves in an even more problematic position than just a poor economy. What are individuals supposed to do when they are faced with a scenario of conflicting information, untrustworthy brokers and lack of knowledge?
It’s time we put this confusion to rest. Sure, everyone is entitled to their own opinion on how they want to invest their money, and I encourage anyone looking to make an investment today to do their research to find the best options. With that in mind, I think I can help shed some light on this situation and explain why we are all so confused in the first place.
First and foremost: nothing is foolproof. When it comes to investing money, there will always be some risk—very few opportunities are guaranteed. How much risk you may take on really depends on your tolerance level. In today’s economy, it’s very clear we are at a point where most individuals want to lower their risk as much as possible and most of us are looking for options to “safely” invest our money with little backlash, and this general move to quality investments means more people are taking note of the confusion around municipal bonds.
Conventional wisdom says that if you buy an investment-grade municipal bond, the likelihood that you will not get your interest and principal paid back if you hold that investment to maturity is extremely small. However, in a financial crisis (similar to what we are enduring now), there is always a chance that people may panic at the sight of any risk and leave municipal bonds, turning to Treasury bills paying a minimal return— resulting in a decline in the value of muni bonds.
Nevertheless, even with muni bonds tied to troubled cities and states, if it’s a general obligation bond, as opposed to a revenue bond, it’s very likely the financials will be sorted out to avoid any default. Moreover, many municipalities across the nation still maintain solid financial fundamentals and as a result are able to offer investment grade bonds—in a time when it appears that rating agencies are inclined to be extra cautious. The simple answer is to be wise, do your homework, objectively analyze the risks with your investment, and look for those areas that others might overlook more because of a general panic and less because of sound principles.
Darhl Peterson has traded in the US Treasury, retail bond, and telecom business sectors for the last ten years. Currently Peterson is a Bond Trading Manager for Zions Direct.
With interest rates at the bottom, any investment in bonds is more certain to decrease as interest rates increase. Trying to time investments is risky. However, as an investment base and a longer holding period this might be considered.
I have been investing in nominal municipal bonds for a few years now, since the last bear. I am very young, still in my early 30′s, and very happy to have done so. Because of my situation, I have mostly taxable investments which as a younger man I thought the only way to go was to load up on low cost index funds, so I was near 100% equity. Granted, I was at the beginning of my accumulation, but the 2000-2002 bear taught me what a mistake 100% equity portfolios are. I stuck to my plan, but it took some time to recover. I decided when I finally got a 401k to fill it with TIPS and commodities in my IRA. Still having too high an equity allocation I offset some of the volatility risk of my taxable stock index funds with individual nominal municipals due to the fact that buying in small lots (5-25) you actually purchase at a lower price and get better yields than a fund would.
I am glad I did. I even went a little down credit quality recently as I did in 2003-2004 to offset the risk of a low interest rate environment, but always stuck to investment grade (BBB or better). Just having an 80/20 portfolio going into this recent bear dampened the volatility enormously. I was able to keep investing through the height of the bear, and because of a pay raise increase my savings rate the last 18 months to offset the losses, which is how as of August of 2009 I am only about 5% down the worst bear market.
Again, I want to stress that I decided to take some equity like risk in my munis because I am young and have a long horizon. Buying Guam GO’s or Puerto Rico highway department bonds is a tad riskier than North Dakota state GO’s or treasuries, but despite the variety of munis I have bought happily, there has yet to be a single default.
I am not saying this strategy is for everyone, but I am just saying that on an after tax basis, municipals, especially mid-credit quality municipals which offer stock-like risk/reward profile, are very, very attractive versus the currently overvalued stock market.
Any fears of rising rates or inflation can be attenuated with TIPS, I-bonds, small amounts of commodity futures, precious metals and the ever present stock allocation as well as a shortening of the maturities of your muni ladder, which is a must rather than just buying them willy nilly because you like the yield. As long as you don’t average much more than 10 years between all your bonds, and you have at least one bond maturing every year, you can capture at least some of the rising rates and the rest of your portfolio can help compensate you as well. As a long term strategy, this is working out.
Again, I had the fortune that I didn’t make a lot of money at the height of the market to invest, and income wise did better “at the right time”, but even as of now, I am impressed how my non-stock investments are dampening the volatility of my portfolio. Barring a huge wave of defaults (hey, I am young, if that happens I would be happy to pick up munis trading at 10% like Arkansas GO’s that eventually paid out in full during the Depression).
What impressed me about munis the most is that even Ba (highest level junk) has about the same default rate as AAA corporates, and investment grade munis have a default rate that is negligible. As long as you avoid industrial development, private purpose, multifamily housing and hospital, especially nursing home issues, in my humble opinion most high income investors would benefit from having munis in their portfolio.
FULL DISCLOSRE: I own munis, but I don’t have an account with Zions. I have one with Stoever Glass whose prices are competitive. Their selection isn’t as good as Zions, but the prices are impressive. I write this piece to encourage anyone to get into munis. They don’t offer eye popping yields or rates of return, but if 2% for a 18 month PRE-REFUNDED issue sounds appealing for a short term investment versus CD’s or money markets or treasuries (all of which are fully taxable), then munis are for you!
Arthur,
We do not offer specific financial advice or consultations on what you should or should not do here at Think. I would encourage you to contact the Zions Direct investment center at 1-800-524-8875, or if you are looking more for investment management, consider reaching out to our fee-based wealth management group, Contango Capital Advisors at 1-510-558-6000.
Regards,
-Russell