As paltry as the returns from municipal bonds are, at least compared to stocks, they still attract a lot of investment, due to investors thinking that they are so safe. Think again.
We’ve been worried for a while about the potential hit that municipal bonds, or munis, could take from this economic shutdown, and we’re starting to see this show its ugly face as we move further into the wilderness of this new frontier of economic surrender that we have chosen.
Even though the default rate with munis has been very low historically, these aren’t historical times, and we’re making new history lately, of a sort that should make municipal bond investors especially concerned.
It’s not hard to figure where the worry comes from, and this problem actually runs deeper than it may appear at first glance. We may think of governments as having unlimited borrowing power, even though even the federal government is subject to limitations. The Treasury can handle anything that this virus can throw at treasuries though, and even with all those trillions thrown into the fray, this hasn’t even come close to tapping out their ability to borrow and create money, even though there will be a price to pay down the road.
This money is all subject to being paid back one day, and subject to is the right phrase here, as we’re creating a bigger and bigger debt monster that has gone well beyond the tipping point and is far too large to ever be reconciled, and we’re forced now to just make the number bigger and bigger until it eventually explodes. We can worry about this later, much later, after we are gone in fact, although state and local governments do not have the same luxury.
It’s not that these smaller governments don’t try to do the same thing, but they cannot just make a phone call to Jay Powell and raise any amount of money and just push it forward as much as they like. This doesn’t bother investors in treasuries much, because they know that the Treasury is good for it, and treasuries just don’t default. They will someday, but that day is pretty far off.
Municipal bonds are very much subject to default, even though they do tend to keep things solvent pretty well in normal times. The tenth of one percent default rate recently doesn’t even concern investors much, as they just buy a basket of them with a fund and whatever losses that occur become so diluted by the overwhelmingly large percentage of them that make their payments as agreed.
This is what it looks like in good times, but good times is not an appropriate term for what is going on now. The U.S. government will do anything to prop up their treasury notes, bills, and bonds, but munis are far more segregated and are much more left to fend for themselves, and aren’t fending all that well lately.
Just like any loan, repayment with munis is based upon income flow, which is the biggest thing that distinguishes them from treasuries. Treasuries basically get paid back by just borrowing more, and our fiscal balance sheet not only does not contribute to repayment, it requires a lot of additional money to be borrowed to feed it, in addition to the costs of servicing this federal debt.
When the revenue base that the repayment of munis is based on starts to dry up, this is a serious matter and especially if the problem is so widespread. If you buy bonds that have been used to fund the gaming industry in Mississippi for instance, and the gaming industry shuts down, they may hold their hands out to the state for relief, but the state has enough to worry about with their own bonds to help. They are in serious trouble as well, and when states hold their hands out, they are for the most part on their own with no one to hand over the money that they need to keep things together.
This economic grief has impacted governments of every size and level substantially, and we might think that all we need is a handout from Uncle Jay of the Fed and things will surely be all right. The Fed has thrown around massive amounts of money at just about everything these days, but their involvement in the municipal bond market has been very limited, with only the largest ones getting helped. The rest are indeed left to fend for themselves, at a time where a lot of them are getting into some real trouble.
The Federal Reserve is really only worried about the big stuff, and not your little bonds that you thought were pretty safe up until this economic crisis hit. They are helping cities of over a million people and counties of over two million, but this leaves a lot of cities and counties and all sorts of other munis out in the cold. The weather is plenty cold now, and may be getting even colder before it warms up. Many of these bonds may freeze to death, and many are close to this already.
Munis are mostly invested in through bond funds these days, and funds rule this market like they do every other market now. Diversification is king, and these funds dabble in bonds of various qualities, especially the high yield funds who actually focus on the riskiest of the bunch. It is not that investing in munis can be made safe these days, but the higher yield ones are by definition riskier, and when risk with munis gets so much more magnified, when you magnify a higher number to start with, that does spell trouble indeed.
We may even wonder what investors are thinking about when they invest in municipal bonds in the first place, given how absolutely terrible their risk to return ratios are, but this applies even more to higher yield ones. We may find the idea of higher yields pleasant, even though the returns of these funds aren’t anything we could call high, and we’re now seeing the darker side of this equation, the risk one, beating those very low returns well into the ground and then some.
We certainly do not want to be fooled by looking at yield here, as the lower yield ones actually outperform the higher yield ones in terms of total return, because they hold their price better, and the net asset price of a fund going down eats your yields. Both types are pretty terrible though, and this is like comparing a piece of cheese that is 20% molded with one that is 25% mold, making you a little less sick perhaps, although no one should want to eat moldy cheese.
High Yield Does Not Mean High Return, or Even Much Return at All
We only need to take a peek at a leading high yield muni fund such as the VanEck Vectors High-Yield Municipal Index ETF to get a taste of what we are talking about here. This was already buried in the investing wasteland even before all this, but things have of course gotten a lot worse lately as revenue streams for these bonds dry up so much and investors get so concerned.
This is actually supposed to be either a hedge to protect investors from falling stock prices or provide those who consider themselves income investors with a reliable, low risk alternative to stocks. As bad of an idea as this has been, we can only hope that the current turmoil will cause investors to wake up more to the reality of these investments, but the beliefs that cause so much money to flow into these investments from retail investors runs pretty deep and it’s unlikely that even this will serve to see many of them become more enlightened.
Calling this fund high-yield does suggest some sort of higher returns, but when we look at its 3- year return, and see its average total return come in at -0.99% that should deeply disturb us. The fact that we do not have to pay federal taxes on this doesn’t matter, as you don’t have to pay taxes on anything unless you actually make money, not just lose it.
The fact that these investments being free of federal taxes is their main selling point, and the threshold of diligence among these investors is so low that this becomes persuasive, which is a sad testimony indeed. This is the pitch that you hear on the commercials for this stuff, and there’s plenty of people around touting them as well, but it seems no one looks into these things because if they did, what’s in the bag is plenty ugly.
The big attraction with bonds in general is how they are supposed to protect you against bear markets, like the one we just have, and taking a look at how this fund has fared during this one is the funniest part of this. Our fund dropped 35%, which should sound familiar to stock investors as this is exactly how far stocks fell. It even tracked back up like stocks did, matching our bear move in lock step, not only offering no protection, no hedge, but also lacking the power to come back like stocks do.
Investing in this so-called high yield muni fund has us giving up all of the good stuff and still ending up with a full serving of the bad. If Charlie Brown invests, this would be something he would probably like, and he’d be the perfect investor for this fund because you could call him a blockhead over and over again and he wouldn’t care, just like in the comics. There are a lot of Charlie Browns out there it seems.
To be fair, people just don’t think about their investments, they consume them just like Charlie and the other kids have their bags out at the doors on Halloween. At least Charlie recognizes that he is getting a rock while the other kids get candy, with the muni Charlies just having rocks put in their investment bags and not even realizing they are rocks.
The big difference between stocks and bonds plays out over the long term, but we can just look at the last 3 years to get an idea of how big the gap is. The S&P 500 has taken a hit but is still up 21% over this time. Our muni fund has only delivered 11%, not a positive 11% though, a negative one. This isn’t just a rock instead of candy, it’s a sharp one draws blood as you hold it in your hand.
Stocks have been going up lately because the future is still fairly bright, as grim as the present may be. Munis are mired in this grimness, and the best that they can do is return to just being a dud that neither requires federal tax nor makes you any real money that you should care about being taxed, and you certainly don’t have to pay tax on losses. It does make a tiny bit normally though, but the value of bonds depends not just on default rates but investor demand, which is what drives stocks higher but not bonds.
Over Time, the Muni Story Remains as Ugly
If we look further out, to take this muni fund out on the highway and let it show us what it really can do over the longer term, the fund has delivered some dividends, but the overall price of it has gone down by 12%, eating into these dividends and reducing its total return to just 3% per year. Anyone alive during this time will have a good idea of how much stocks moved up during this time, with the S&P beating this by 13% per year.
Given the choice between 16% a year and 3% a year over this time adds up to an additional gain of 130% over this time. The most you would save in tax from the munis over paying the capital gains tax is 20%, if you make almost half a million, still leaving you up 11.2% a year over tax free munis, and those with a household income of $78k and under don’t pay any capital gains tax. This is a fool’s gambit to be sure, a big one, blockhead sized.
We’ve already seen some defaults, with a tire-recycling plant one in Indiana, one funding a nursing facility near Boston, and one in Kansas used to fund a YMCA all being knocked out by the dreary economy of late. There’s a whole lot more on the brink, with several down to begging for mercy from their bondholders to avoid going under.
This puts bondholders between a rock and a hard place, being forced to choose between getting a portion of the debt owed to them back through default proceedings or giving up interest payments to keep the bonds solvent. Neither prospect is very exciting, and serves to lower the number of peanuts that they earn even more.
Lower yield muni funds don’t fare much better over time, for instance the iShares National Muni Fund ETF only has averaged 3.7% over the last 10 years, which just means investors get a little bigger handful of peanuts but not something that is going to take you too far. When you take out inflation, you barely have much more than you started with instead of doubling or tripling your money just by investing in stock indexes. The Nasdaq one has beaten this premium muni fund by 28% per year over the last 10 years when we compare total returns, and the higher yield one even more, but not by much as both these bond funds perform terribly.
If we ask Charlie why he has chosen crumbs over cake, we’re not even sure what he would say, but he probably would tell us that crumbs don’t scare him but big pieces of cake scare him too much. A big piece of your cake can fall to the ground and you will still have much more of it than just crumbs, and this is the big lesson that Charlie needs to learn.
The cake isn’t scary, but his thinking sure is. There is no point over this time when munis were ever ahead, betting on this old mule that plods around the racetrack and keeps getting lapped by the real horses. When both are underfed like they are now, the mule can barely stay on its feet now, and who knows how much uglier its fate will become as it loses more weight.
We don’t want to forget about the racecars, ones that drive circles around these indexes. Tesla in ludicrous mode can make more money in a few short months than bond investors can make over their investing careers. Tesla may be too dangerous of a ride for most, but there are plenty of fast cars out there that both have the speed and the ability to stay on the track better, stocks like Amazon which have returned over 200 years’ worth of bond returns just in the last 5 years and will continue to lap them in the coming years.
This is like the tortoise and the hare story, but in real life, the hare builds up such a lead that it can afford to take naps and still remain well ahead and win the race every time by a huge margin. Both may be a little sick now, but the hare is back on his feet, and the tortoise is about to be stepped on, and this is the worst time to put your money on it, not that there ever is a good time.