Individual investors love municipal bonds.
In fact, they directly own about 44 percent of the $3.69 trillion in munis outstanding. Mutual funds — often used as a proxy by individuals to indirectly invest in the market — own another 28 percent.
Conversations I’ve had with investors at conferences and elsewhere tell me the same thing. They want yield, and they think munis are a safe place to get some, especially with the tax exemption “kicker.”
That’s true historically. Munis very closely tracked Treasuries, with very little “risk premium” built in. But are munis as safe as bonds issued by Uncle Sam anymore?
|S&P’s downgrade of Puerto Rican bonds to junk status puts added pressure on the muni market.|
That view sure is getting tested. First there was Detroit, which filed for bankruptcy last summer under the crushing burden of $18 billion in debt and other long-term liabilities. Many investors tried to shrug off the filing as a one-time event, something years in the making.
Then concerns flared about Puerto Rico, a much bigger player in the municipal bond market. The U.S. territory has $70 billion in muni bonds outstanding. Its bonds are sprinkled throughout 70 percent of the mutual funds that own munis, in part because they’re exempt from state and federal taxes.
Weak economic growth and elevated unemployment have put pressure on the Puerto Rican government’s finances. So have long-term pension obligations. As a result, Standard & Poor’s just cut the island’s rating to BB+ from BBB- this week, putting it in junk territory. That could reportedly exacerbate Puerto Rico’s cash crunch by forcing it to front an additional $1 billion in collateral and swaps payments.
The iShares National AMT-Free Muni Bond ETF (MUB) is my favorite benchmark ETF for tracking muni prices. It already lost a little more than 6 percent last year, and it took another hit in the wake of the S&P news. So did the Market Vectors High-Yield Municipal Index ETF (HYD), which invests in the higher-risk portion of the muni market.
I would be alert to the possibility of even more declines in the months ahead. In fact, I recommend paring your muni exposure dramatically. That is, if you didn’t already heed my advice to do so more than a year ago before the 2013 losses.
First, I don’t like the outlook for bonds overall, with interest rates likely to rise once the recent correction runs its course.
Second, if you layer rising credit risk on top of rising interest rate risk, where does that leave you as a muni investor?
With losses, that’s where! If you need to invest in any part of the fixed-income market, stay in high-grade corporate debt and stay in very short-term maturities — less than two years.
Until next time,