May 11, 2012
Written By Jack Colombo
Many income investors like municipal bonds for their tax advantages and yield. But the two experts below have some warnings about the sector.
“I am frequently asked about municipal bonds and why I have not recommended them in this newsletter. The short answer is, I don’t like them. The longer answer is, why? After U.S. treasuries, municipal bonds were considered the safest investment instrument. Hence, you could get a safe return and feel you were helping your community or state.
“Munis have the added advantage that they were generally free from state and federal income tax, although many investors have clearly not done the math in this regard. I regularly see individual accounts with muni holdings where the client is in a low tax bracket. I even see munis in IRA accounts, a clear case of turning tax free income into taxable income (when distributions are made).
“Build America Bonds, or BABs, which are taxable muni bonds with a patriotic cachet, seem to have been created to fill this apparent need. Municipal bonds are popular among the elderly and their offspring who inherit them and know nothing about investing other than that gramps was good at it, or so he lead them to believe. While the default risk in munis remains low, it is certainly rising. But even if such risk is rising, the history of salvage recoveries in muni defaults is quite good. No, it’s not default risk investors need to fear in munis, its interest rate risk and legislative risk.
“Interest rates will be going up in the next five years, without a doubt. Why then would you lock yourself in for a 2% or 3% rate of return when inflation is already running near those rates? For that matter, why would you buy TIPS with a negative interest rate yield of -0.36%? The only rational explanation for such an irrational act is either investor lethargy or institutions whose primary investment goal is asset preservation.
“As for legislative risk, it is clear that government is on a program to tax the wealthy and taxing their accumulated wealth via negative interest yields is way easier and more productive than trying to tax their income. There is a clear policy trend of decreasing both the supply and the flexibility of tax-free munis, thereby only adding to the decline in yields.If you are more interested in asset preservation than income, munis may still hold an attraction. However, unless you can buy munis in $100,000 lots, you will find them costly to trade and illiquid. My advice is to buy a good [muni bond] mutual fund that can provide you liquidity, fairly good default protection and quick exit when interest rates normalize.”
Jack Colombo, Forbes/Lehmann Income Securities Investor, May 2012
“The front edge of the coming bond-default tsunami is clearly visible in our discussion of the burgeoning credit crisis in Europe. Less publicized, but every bit as important, is the debt burden that is smothering U.S. municipalities. [Robert Prechter’s book, Conquer the Crash,] warned that muni bond tax-exemptions would ‘ultimately trap investors into a risky position,’ and EWFF [Elliott Wave Financial Focus] has continually stated that defaults will rise as cushy municipal pensions and health benefits garner a bigger share of a decreasing tax base.
“In December, EWFF identified the largest municipal bankruptcy in history—Jefferson County, Alabama—as an important harbinger. On Tuesday, administrators of Alabama’s largest county said they may close courts, stop meal delivery for the elderly poor and eliminate building inspections. Additional cuts are inevitable. ‘Everything is indeed on the table,’ says the Birmingham News. According to Reuters, defaults quietly skyrocketed in 2011, jumping $25 billion to nearly five times the 2010 total. In the first quarter of 2012, defaults doubled again. And this is occurring with the DJIA rising! When the larger downtrend resumes, look for a torrent of municipal bankruptcies.
“Despite the rise in muni-bond defaults, investors remain amazingly complacent. This chart shows the ratio of 10-year AAA muni yields relative to 10-year U.S. Treasury note yields. The ratio rises when muni investors demand higher yields relative to Treasuries due to a perceived increase in risk. The spike on the left side of the chart occurred in the fourth quarter of 2008 in conjunction with the first phase of credit deflation. The ratio’s low occurred in December 2009, at 79 basis points. A creeping rise through 2010 and 2011 led to an interim high of 145 basis points on October 3, 2011, in conjunction with the stock market’s decline into a low on October 4. As stocks rallied and optimism once again increased, the ratio pulled back to a March 19 low at 104 basis points.
“Interestingly, the Dow’s rise to a new recovery high this week was accompanied by a rising muni-to-treasury ratio. … Muni investors have so far shrugged off the increased risk of defaults. But as Richard Ciccarone, the managing director of McDonnell Investment Management notes, ‘This is a lagging process. Capitulation may not come for years. In the crash of 1929, the defaults did not come until 1934 or 1935.’ With Primary wave 3 in stocks still ahead, as well as the most virulent portion of deflation, the muni-to-Treasury ratio should spike to a record high, sailing past the 2008 extreme of 196 basis points.
“We state emphatically: Municipal bonds are no safe haven; they are a trap.”
Steve Hochberg and Pete Kendall, The Elliott Wave Financial Forecast, May 4, 2012