Exceptional Exceptions

In a world that includes dozens of US Treasury bond issues (but just one credit) or hundreds of Corporate bond issuers, Municipal bonds offer tens of thousands of different credits, terms and conditions.  It is these differences, rather than their similarities, between issuers and issuances that account for the robustness of the municipal bond market.

I do not pretend to know or understand the motivations of why municipal bond owners decide to sell one of their bonds.  Perhaps they choose to sell a bond because it has Detroit in its name or is located in Wayne County or merely resides in the state of Michigan.  I do not know the motivations of sellers but I am glad municipal bond owners do decide to sell because this is how you and I build our portfolio of municipal bonds.

I also know that areas of financial stress such as Florida, California, Arizona, Nevada and Michigan are where we have purchased many worthwhile municipal bonds over the past several years.  We have even found and invested in worthwhile bonds in cities like Stockton, San Bernardino and Detroit that eventually filed for bankruptcy.  Municipal bonds by definition must have a municipality in the name.  Whether the name of the bond has much to do with the credit quality of the bond may be a separate matter.

Some municipal bonds are better secured than other municipal bonds.  In fact, some bonds may not be secured at all (think IOUs).  Whether a bond is secured or unsecured does not make one bond good or another bad; many unsecured bonds are worthwhile.  However, things can and do change and they can change quickly and become quite ugly.

Because municipal bonds tend to trade around 100 cents on the dollar and mature at 100 cents on the dollar, most of the risk in bonds tends to be to the downside.  Years ago (decades ago) bonds were believed to be safer (than stocks for example) so even downside risk was minimal.  This is the history of bonds in general and municipal bonds in specific.  But that is only history; we care about the future.  As issuers of bonds discovered that more and more leverage could be taken on by municipalities, the downside risk could become quite tremendous.  Detroit is talking about settling some bonds at 20 cents on the dollar or less.  No amount of yield, particularly yield at 5%, can compensate for the risk of principal loss from 100 to 20 cents.  It is this reason that marginal credits in the municipal bond market are not worthwhile.  Nothing against Detroit as I feel the same way about Harrisburg, PA., Puerto Rico and hundreds of other bonds that I routinely ignore in the marketplace.

There are times when risks are low in the municipal bond market and other times when risks are ratcheting higher.  When credit is expanding, investors are demanding bonds and Wall Street is happy to oblige, these are times of low risks.  Back last Thanksgiving as the municipal bond market was peaking in price, yields were low at around 3.25% for 20 Year General Obligation bonds.  The yield curve was also quite flat at about 230 basis points between 1 year and 20 year yields.  With low yields and high prices the belief was strong that risks were low.  And of course this all changed, dramatically and swiftly.  Yields are now about 4.75% on those 20 year bonds and the spread is now about 410 basis points between short and long term bonds.  Investors have dumped bonds, municipal bonds included, and prices have fallen dramatically.  Obviously investors are feeling bonds are not quite the risk-less investment they seemed to be just a few months ago.

These are the risks we have avoided in our municipal portfolios.  Not only do we avoid marginal credits that can become bankrupt credits literally overnight, but we have avoided longer term bonds and their price volatility as well.  Higher interest rates mean, in general, fewer refunding bonds are issued and thus bonds last longer than they might otherwise last.  Often times we invest in bonds we believe will last longer than their call date might indicate.  This is why we are so credit quality conscious on the front-end so later we can cheer for higher rates (and longer bonds) on the back-end.  As a result of this selection, the higher interest rates of the past year have been a blessing while at the same time the very same higher rates are proving to be disastrous for other municipal bond portfolios.  Selection is the key.

Treasury bond yields have moved to even higher levels of late, exceeding their July 2013 highs to new two year highs.  This of course is horrible news for investors in Treasury bonds, particularly long-term Treasuries.  A year ago we had low (to no) inflation to justify low 2.65% yields on the longest Treasuries.  Today we have the same low (to no) inflation and 3.85% yields.  If you think interest rates are correlated to inflation, I have news for you.  Bond prices have nothing to do with the level of inflation.  If you believe that bonds are a good long-term investment because you see low inflation continuing, I suggest you check your narrative.  To paraphrase Keynes: the bond market can remain illogical longer than you can stay liquid.

Bond prices have dropped and are dropping and I believe will continue to drop because so many have been issued.  As long as investors wanted bonds and more bonds, all was well.  Now that investors do not want more bonds, well, watch out.  This was the risk I saw in 2007 and it was the risk I have been watching the past several years before concluding that Thanksgiving 2012 marked the end of the great municipal bond bubble.  With the bubble now almost a year old, the Treasury bond bubble even older and corporate bonds and mortgage bonds also included, bonds, in general, are a horrible place for investors funds.

What you as a client of The Select Group at The Select Approach^TM have working for you is that the municipal bond market offers something exceptional.  The municipal bond market has tens of thousands of issuers and even more issuances of what are often times unique investments.  Every bond issuance has the opportunity to be unique and many actually are unique.  This is all by virtue of the bond indenture that makes the municipal bond possible.  This uniqueness can make municipal bonds an exception in the bond market and we are seeking to find the exceptional exceptions.

We don’t have to do things differently simply because moods have changed regarding bond investments.  Thankfully The Select Approach^TM works when everyone loves bonds and investors throw caution to the wind and ignore risk.  We worked in this environment from 2009-2012.  We also know The Select Approach^TM works when rates rise and bond prices fall, as they did in 2007-2008 and again beginning late last year.  This is excellent news to discover that you do have alternatives of where to invest even when volatility and lower asset prices seem to be coming at you from all (other) directions.

I continue to look for and prepare for a greater sell-off in bonds and now for stocks to join the fray.  The narrative is not about low inflation or low growth or even continued (low) earnings.  The narrative will be written about the end of excessive leverage and the return of Credit Expansion Finished.  It is the end of the great bond issuance that will mark the end of the great bond market bubble and that day is already behind us.  Credit Expansion Finished will quickly give way to The Great Credit Contraction and I believe the end result is dramatically lower asset prices across the board.