Municipal Bonds and the “New Normal”

Saturday, 17 July 2010 09:44 Last Updated on Saturday, 17 July 2010 09:54 Written by Sharlee L. Cretors

I recently participated in an educational call sponsored by Pimco, one of the largest bond managers in the world.  I respect their opinion not only because of their leader Bill Gross but the entire Pimco team is like a who’s who in the bond world. They manage some of the largest bond funds in the marketplace as well as recently offered to manage bond ladders with advisory services such as ours for a fairly reasonable management fee.  That being said, when they offer to share their perspective in an area we specialize in, municipal bonds, we wanted to listen. 

Many of you may have heard the term “new normal” which was coined by none other than Pimco themselves.  In defining the new marketplace and the “new normal” they believe that we as investors and citizens will be seeing much slower growth than we have in the past, higher unemployment rates and new economic conditions for our municipalities never seen before.  In the past the municipal market was equated as one step away from the safety of a Treasury Bill and the real risk with Municipal Bonds was that of interest rate risk, having a bond that pays lower interest than what may come available in future years.  Credit risk, or credit worthiness was seldom a great consideration when buying Municipal Bonds.  After all, insurance companies like AMBAC were insuring these bonds so if the municipality couldn’t make their payments, the insurance company would step in..right? Wrong!  Since the financial meltdown of 2008, those same insurance companies are battling for their own survival and most savvy bond buyers disregard them as a viable replacement for good sound fundamentals of the issuing municipality.  In addition we have 48 out of 50 states running budget deficits, many states have pension plan liabilities that are not funded and with the upcoming elections you can be sure there will be plenty of finger pointing as to who is most at fault for the current state of affairs. 

This leads us to today, what should an individual be considering when buying Municipal Bonds?  Credit quality.  Let me repeat, Credit quality, that is right, it is most important today to make sure when you are buying a bond that you do the appropriate diligence and investigate the municipalities ability to repay you before you decide to lend it money.  Credit is the most significant risk an investor faces in today’s bond market. Municipalities are more like corporations now and must be reviewed on their ability to pay, independent of insurance, government bailouts and the like.  This makes what was once a simple investment something much more complicated and difficult to navigate.  As an advisor we have resources and tools from which we can perform this type of diligence as well as employing the management expertise of companies like Pimco in managing our client’s bond allocation.  We would recommend anyone looking to invest in municipal bonds to seek the advice of a professional as this isn’t your father’s municipal market anymore. 

Some recommended rules of thumb to use when investing in bonds:

• Consider your time frame for needing the funds, having to sell before maturity can mean a loss of principal
• Understand the risks you face in bonds, credit, interest rate and inflation risk
• Bond funds are a good alternative for smaller amounts as they provide diversification but no principal return guarantee
• Keep with higher rated bonds, at a minimum Investment Grade (BBB) or better, we prefer A rated or better given the current environment
• Defaults are going to occur more often as well as municipalities claiming bankruptcy, do the research up front and monitor on an ongoing basis
• Do not depend on the Federal government to bail out these municipalities, there is not even an implied guarantee for these bonds
• If you find a bond that yields more than others of the same time frame, then you are looking at a riskier bond.  Remember risk for returns works in bonds too.
• Consult a professional when considering bonds, either with a bond fund manager, or investment advisor who specializes in these instruments.