Look Out Below! Municipal bonds could lose you a lot of $$$$ - Excerpt from our March, 2013 Special Commentary

Muni bonds can be hazardous to your financial health. After providing good income and even better total returns, intermediate and long municipal bond investors are at risk to losing value. Almost $2 trillion of municipal bonds are directly owned by individual investors today.  The income from these bonds are exempt from Federal taxes.

What’s not to love? Plenty, in our opinion as we look  into likely scenarios in the future and foresee a major financial accident in the making. No, we don’t mean a recession or global systemic meltdown a la 2008. Rather it is the value destruction that will result from rising interest rates on what is supposed to be the safe part of one’s investment portfolio – bonds. Interest rates are near historic lows and the majority of municipal bond maturities are long (an estimated ¾ of municipal bonds mature in seven or more years and $500 billion mature in 15 years or more) . The good news is that investors are enjoying decent yields in an environment of financially depressed alternatives (CD are now being described Certificates of Depression reflecting their paltry yields). The bad news will be painful as the interest rate risks inherent in high priced, long maturity bonds is startlingly huge.

There are two other headwinds to municipal bonds today as trading is less liquid and credit risk is higher. Less than 5% of muni bonds issued last year were insured. All fine and good, you say, but what does it have to do with me? I like the income I am getting from these bonds and I am confident I will get my money back. While the income stream from these bonds is reasonable (especially after we tax effect them for not paying Federal taxes), your effective “yield” on these bonds is lower. These bonds are trading at a “premium”, much higher than their par value, so the current income represents a lower yield on their current market price than when you bought them. The market yield (or yield to maturity) is even lower as it factors in that the price of the bond will drop back to par as it nears maturity. Bond investors who hold these securities until they mature will get their initial investment back and the interest income in the interim but they will lose the premium that these bonds are currently trading at – guaranteed!

Time to act? What’s the hurry? Isn’t the Federal Reserve committed to keeping interest rates low until unemployment is below 6.5% (currently at 7.9%)? Yes, but as the biggest buyer of long dated U.S. Treasury bonds in the market, it will eventually not only stop buying them but may eventually sell them pushing down their price (and increasing their yield). The market will try to anticipate this and when market interest rates move up they may do so violently! Major financial transitions always end in tears. We think this is one financial accident that you can avoid and being too early is better than regretting inaction after it is too late. A rise in the current 30 year bond yield from 3.2% to 6.2% may result in more than a 25% decline in long muni bonds.  

Better to be early and protect principle than to chase a little yield at this juncture.  To see the full commentary go to www.regencywealth.com.  Call us if you would like to discuss this further!