David Hammer of bond king Pimco is doing his best to drum up more interest in municipal bonds. Their little scare may be over, but there’s little to be excited about here.
There are three main types of bonds that people can invest in, which are sovereign bonds issued by federal governments, such as U.S. treasuries, corporate bonds issued by companies, and municipal bonds, commonly referred to as “munis.”
Municipal bonds aren’t just issued by municipalities, in spite of the name, as this category covers all other government issued bonds besides those issued by federal governments. This covers a lot of ground, anywhere from bonds issued by a city’s transit system or other part of a city’s government that needs to borrow, right up to bonds issued by state governments.
All governments need to borrow, as they all rely on deficits and only get a portion of their revenue from taxation, and need to issue bonds to make up for the rest. The idea of this should trouble us at least somewhat, as we may wonder how worthy their credit would be if they need to borrow to pay the bills, and this would be a big deal indeed if it involved non-government borrowing to do this, like if we tried this ourselves or even if a company tried it.
The U.S. treasury does the same thing though, and runs trillion dollar per year deficits these days, an amount that is going to be going up significantly from all the extra spending that they are doing to combat the economic straightjacket that governments have put us in lately. However, treasuries differ in important ways from munis, starting with the fact that the treasury can borrow money more readily than state and local governments can.
Even this has its limitations though, as we speak of on here from time to time, with a wary eye toward the future. The borrowing ability of a government is defined by the market for this debt, in this case the treasury market, which is still enormous and still commands a high degree of confidence that the treasury notes, bills, and bonds that are out there in circulation will be paid in the agreed-upon manner, although this well will eventually be depleted.
The losses from the coronavirus panic to the treasury aren’t just limited to these multi-trillion’ dollar payouts, even though the $2 trillion that has recently been earmarked for this may not be the end of things on the spending side. This all depends on how long we want to keep the economy constrained, as well as re-assessments that may have us wanting to do even more bailing out through the duration of this lockdown as politicians see fit and the need for further help increases over time.
There’s also the revenue side of the treasury taking a hit, and this applies not only to the U.S. government, but to all governments large and small. This is especially a concern at the state level in the states that have locked down their economies, such as New York and California, among others. When states and other governments are restrained both by a lot of extra spending and a lot less tax revenue, this is not a situation that should make us all that happy about holding their debt.
There is no risk of the U.S. treasury going under right now, even though one day this will be inevitable, because you can’t just accelerate the amount that you borrow forever. If there were no limits to this market, where you could continually issue treasuries and someone will buy them and lend you money, we could extend this forever, but the people of the world only have so much that they are willing and able to invest in treasuries, and eventually this market will dry up and the U.S. government will have no choice but to default.
Long before this happens, smaller governments will meet this fate, including all governments that issue municipal bonds. Munis have been remarkably stable thus far, at least as far as bonds go, although they are always considerably less stable than people think and their prices can still move around quite a bit, as we just saw earlier this month.
It is fairly commonplace for munis to lose a half a percent or more during a downward move, for various reasons, the biggest of which is a relative loss of confidence in them with investors. We just saw a bout of this, and while the speed of this was unusual indeed, where these moves normally take months to play out, not days, munis do follow bullish and bearish patterns like other bonds do, and they can move a fair bit over time, relatively speaking that is.
A lot of investors love to ignore price fluctuations with their bonds, not just with munis but with every other type as well, pretending that they are just in it for the yield and prices don’t matter. You still have to sell them at some point though, and the capital losses that can arise may pale in comparison to what can happen with stocks, with the latest bear market being a good example of this, but we should not just ignore something that can have a substantial impact on our rate of return.
The bond market is nowhere near as accessible as the stock market, and prior to the emergence of bond funds, people had to buy them individually and had to meet minimums that were simply too rick for a lot of people’s blood. Bonds themselves do not trade on exchanges like stocks do, but they have been available through buying mutual funds for quite a while now, and with exchange traded funds, you can even trade them like you would stocks.
This has opened up a whole new world to individual bond investors, who no longer have to put their eggs in one basket or not even be able to afford a single bond, but just because you can readily trade bond funds doesn’t mean that you should. There are some particular considerations with munis that we have to be aware of, concerns that go beyond the paltry returns that they provide.
Treasuries Are Vastly Superior Structurally to Munis
During times of trouble, treasuries just keep soldiering on, and the demand for treasuries actually go up during these times as people flee other investments such as stocks to jump on board the treasury train. The federal government needs to borrow even more these days, but the market can handle it without any trouble, and they also have the Federal Reserve to buy treasuries from them, which the Fed is lustily doing right now.
This is a lot like playing monopoly by yourself, where you’re both the player and banker, and if you need money, you just take it from the bank stack. There is only so much money in that stack, but we’re a long way away from exhausting it, even though we’ve moved closer than ever lately with all this extra borrowing.
Corporations, on the other hand, are limited by both the market and their peculiar situations, and if they run into trouble, they will have to pay higher rates to borrow as the market becomes leerier of the risk involved and their bonds become downgraded to reflect this. They don’t need a downgrade to feel this pain though as the market itself will control this, looking at their numbers and their changing risks and demanding more return to compensate them for this.
The same thing actually happens to some degree with munis, and munis are much closer to corporate bonds than they are to sovereign bonds. Investors do pay particular attention to the solvency risk of munis, and like with corporate bonds, their outlook will substantially shape their value.
When the economy is running smoothly, this is beneficial to both corporate and municipal bonds, as companies will make more money and governments will take in more revenue as well. During times of economic pressure, we need to be more careful with both. It’s obvious why a company that is doing little or no business would be a big concern, but this even applies to municipal bonds, even though we care a lot less about how much in debt that these governments hold, less than we should actually.
Bond prices are more about confidence than anything, starting with treasuries which investors are completely confident about, enough to call them risk-free. Munis compete with both treasuries and corporate bonds, where they earn higher yields than treasuries do because they are riskier, and lower yields than corporate bonds because these bonds are riskier than they are, or at least are perceived to be.
The stability of both municipal and corporate bonds is completely dependent upon the capacity and confidence of bond markets though, where they can keep borrowing as long as people are willing to lend to them by buying their bonds. Debt with companies waxes and wanes, where municipal bond debt just keeps growing, like federal debt does. They don’t have a money- making machine at their disposal like the U.S. Treasury does, so their ability to keep pushing debt forward is a lot more limited.
Munis would represent a smaller portion of the bond market than they do, if not for the fact that they are federal tax-exempt in the U.S., which in practice has a lot bigger influence in this market than we would think based upon crunching the numbers. There is something particularly appealing to a lot of people about paying less tax, and this has plenty of people preferring munis on both a return and risk basis beyond what the numbers should provide.
Investment decisions always come down to comparing risk and return, and municipal bonds overall may actually be the least appealing investment we could ever make in this regard, given that their risk tends to be understated and their returns are so small. For instance, we could compare Amazon, who is making plenty of money and is expected to increase this more and more over time, with New York City, whose debt levels are already concerning and this is set to become even more concerning with time, especially with the added damage of this lockdown to account for.
Over the last 10 years, munis have averaged an annual return of under 4%, while Amazon has averaged 150%. Amazon clearly wins huge on the return side, but this is also a company that is far more solvent than New York City or any municipal bond issuer for that matter, because Amazon is set up for long-term success while governments are all set up for long-term failure.
We may think that we only need to worry about default risk, where some may even say that the default risk with munis aren’t that much higher historically than treasuries, and it is true that defaults are not that common with munis. If you invest in a fund, the diversity that this provides should protect you against isolated default risk, although this doesn’t help you against systemic risk, which is much more common.
We cannot make the mistake of looking upon the past for default risk though, at periods in time where it has been quite low, and look to project this into the future. Risk with munis will be increasing over time, due to the nature of how governments borrow, and when we see public debt go up at alarming rates, this in itself should give us pause for thought.
The risk involved here is more than just default risk though, which someone who only sees these as like savings accounts would, as price risk will become more and more considerable as time goes on. We might think that this may not happen until long after we are gone, like we do with treasuries, but muni price risk is already here, and is set to grow each year.
Munis At Least Make More Sense Than Treasuries Now
We got a good glimpse of this recently, with the benchmark Vanguard Intermediate-Term Tax Exempt Fund dropping over 10% in less than two weeks earlier this month. Sure, this was from a systemic shock, but even though the drop was a lot more compacted than we normally see, this loss of confidence can also manifest over time, and put us in the same undesirable place.
This is the capital risk side of munis, and while this applies to all forms of bonds, this needs to be added to default risk to get to total risk. We know that these governments are in worse and worse shape with each passing year, a fate that will only be worsened if economic growth slows down even more, and this both increases default risk and systemic risk. We cannot forget to add in the particular risk that each issue may face, with the situation in Puerto Rico serving as a good example of how significant this can be.
New York City isn’t all that rosy either, and it’s not a matter of if the city will become bankrupt, but when. While they still have quite a bit of breathing room, their high tax rate continues to drive people away and these latest events hasn’t done much for them either.
This is not to say that these bonds are simply too risky, as risk always has a price, just not a price this low or anything close. This is not unlike choosing a rubber snake over a big teddy bear at a carnival game, and getting one and a quarter rubber snakes instead by virtue of the tax exemption doesn’t improve the deal in any meaningfully way.
David Hammer, the head of municipal bonds at Pimco, has just stepped up to the pulpit and told us all that “there is an attractive risk/reward in high-quality munis.” He adds that “when we get on the other side of this and things normalize, we’ll be left with a world of very low rates and increased demand by U.S. savers for high-quality tax-exempt income.”
Perhaps you find rubber snakes attractive though, and Hammer sure appears to, although we should expect the head of munis to not look to try too hard to talk people out of them. We are at a loss though with how anyone could find getting these very low yields to take on the risk involved here attractive.
These low rates can’t stay low forever, or for all that long, and bonds are the last place you want to be when they go up. You’ll be hit with the double punch of higher inflation eating away your returns, and the value of your bonds going down significantly.
His view is a very limited one, but so is a lot of his clients and a whole lot of people out there in the investment world. However, In spite of their having real price risk present with munis, it is nowhere near as high as the price risk with treasuries right now, especially when we get back on our feet.
Munis are still beat down somewhat, with their only making back a little over half of their losses, and if you had some money to plunk down on bonds and had to choose between this bond fund and a treasury one, going with the muni fund could even be seen as a no-brainer, even though having one would help us understand why neither are actually a very good idea right now.
Our muni fund is pretty much exactly at the same price it was back in 1993, and while they have taken quite a few meaningful excursions along the way, its price isn’t massively bloated like treasury funds are. When we could choose blahh over eeek, boring and impotent can end up being more enjoyable, or less unenjoyable to be more exact.
A lot of people want to make this about yields, and the reason why munis should be seen as preferable over treasuries have nothing to do with yield, with our shooting for 1 to 2 percent right now instead of less than a percent, and it also has nothing to do with saving a little tax with munis.
It has everything to do with the market though, and bond funds do indeed change in value over time, even though this may not be easy enough to see with your hands over your eyes. Treasuries are very overbought and can only really go down in value from here, while munis are not exposed anywhere near this much.
Why so many investors are so attracted to bonds in the first place is the biggest mystery, and it actually is a mystery because it’s not as if there is even a decent argument for this. We can only assume that this has arisen merely from investors taking direction from the industry so well, and the illusion that has been created is so strong that people don’t even seem to notice when their investments go up and down.
They simply aren’t looking, and if you can manage someone’s money and achieve this sort of immunity from blame, if what you might be blamed for is not even part of the package, this is a situation so ideal for the managing firms that it’s hard to believe.
With the coming bonanza in stocks due to correcting what surely is the all-time pinnacle of paranoia in the world, this casts an even bigger shadow over bonds, munis included. When you stand to make 10 years or more of bond returns in a very short period, at a very appealing level of certainty, this offers such a favorable ratio of risk and return over bonds that we may wonder why anyone would be holding any bonds during this.
There are just some folks who have bonds tattooed upon their brains and cannot possibly break free of the idea, and to these investors, it at least makes more sense to be in munis than in treasuries right now. More advanced thinkers will wonder whether either makes sense now.