Is it safe for retirees to tiptoe back to the municipal bond market?
I ask because this normally quiet and sleepy market suffered nothing less than an earthquake in March. In just nine trading sessions, for example, the iShares National Muni Bond
plunged 13.7% in one fell swoop, wiping out for years any advantage the ammunition would otherwise have over other bonds. High Yield Munitions Have Got Much Worse Results: The Van-Eck Vectors High Yield Municipal Index ETF
dropped 36% from late February to mid-March.
The munitions market in April calmed down somewhat after this extraordinary explosion of volatility, and munitions bonds recovered some (but not all) of their losses in mid-March. With the dust largely deposited, daring retirees and future retirees wonder whether they should return to the Muni arena or even increase their preexisting exposure.
A first sign that it might be safe to return is that the premium / discount at the net asset value at which the equipped ETFs are trading has returned to low levels. As you can see from the attached graph, the MUB traded with an extraordinary 5.8% discount from its net asset value on March 18, after having continuously traded in previous months with a very small discount or premium. This revealed huge turmoil in the Muni market. Since then, as you can see, the MUB has returned to trading near pre-March standards.
Of course, this does not mean that the furnished bonds represent attractive investment opportunities. It just means that the market is trading again in an orderly fashion, which I see as a prerequisite for examining the sector.
To begin with, let’s compare the bonds provided with Treasurys, where the munis certainly seem to be the best bets. Investment grade munitions with 10 year maturity currently earn much more than 10 year Treasury, for example – 0.91% vs. 0.68%. This is exactly the opposite of historical standards, since munitions generally earn less than comparable treasury bills, since they are exempt from federal taxes. The fact that they are not suggests that the munitions are much more in disgrace at the moment than Treasurys.
All else being equal, therefore, ammunition is more preferable than treasury bills for the fixed income portion of your portfolio.
But are other things equal? Many say “no” because of the coronavirus pandemic, which has put the finances of many bond issuers at risk – particularly states and municipalities. This concern about the risk of default was exacerbated by comments in April by Senate Majority Officer Mitch McConnell that states and cities should file for bankruptcy rather than rely on a federal bailout.
This concern about the risk of default is exaggerated, however, according to many Muni advisers that I am. Legal experts argue that it would be unconstitutional for the federal government to allow states to declare bankruptcy, for example. Anyway, many of these advisers add that the last thing the federal government wants right now (despite what it might say) is that there is a wave of state and city bankruptcies . And while there is a debate in Washington over the details of a stimulus package for states and localities, most seem to believe that some sort of stimulus will be adopted.
Furnished against corporate bonds
The retirees of choice and future retirees must do for the fixed income parts of their portfolios is not just between Munis and Treasurys, of course. Corporate bonds are another option.
And the risk of default is a good sequence to discuss, because this risk is not negligible among issuers of corporate bonds. Historically, in fact, corporate bond default rates have been much higher than for the munis.
For discussion purposes, however, assume that the risks of default between the two are comparable. In this generous assumption, once we control the credit quality, the rates provided should be equivalent, after tax, to the rates of corporate bonds.
Are they? The table below shows recent rates, courtesy of the Federal Reserve of St. Louis and Bloomberg:
|Maturity||Average high quality corporate bonds||After-tax yield on corporate bonds for the investor within 35%||Muni Investment Grade Medium Bonds|
Note that throughout the term, higher quality bonds produce a higher after-tax return than comparable munis. From this you can conclude that one of two things must be true:
• Premium corporate bonds are better deals today than munitions;
• The risk of default for issuers of first quality companies is significantly higher than for those with munitions.
It is beyond the scope of this column to take a position on which of these two is the correct answer. But what this discussion does is focus your attention on the right questions to ask. If you are sure that the risk of default is not higher for companies than for munis, you will want to favor investment grade companies for the fixed income part of your portfolio. If you don’t, the ammunition becomes more and more attractive.
The assumption in this discussion is that you are investing in a taxable account, of course. If you invest in a 401 (k), IRA or other tax-deferred account, the after-tax returns for munis will be the same as their overall returns. In this case, you would only choose munis insofar as their overall yields are higher than those of comparable bonds which are not munis. For the moment, this means that you would prefer munitions only over Treasurys.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert assessment follows investment bulletins that pay fixed costs to be audited. Hulbert can be contacted at [email protected].