Municipals, Bonds Without Peers

When will the Federal Reserve raise interest rates?  This is the question investors want to know.  Yet I will tell you, it does not matter.  The market tells us interest rates began to rise in 2012; the market will tell us how fast interest rates rise from here.

Rising interest rates are the bane of bond investors.  In a zero interest rate environment every basis point, one hundredth of one percent, matters because we have compressed interest rates to record lows.  Never before, in the history of money, banking, borrowing and mankind have interest rates been lower.  In other words, never before have bond prices been higher, except in 2012 when bond prices began to reverse course.

One cannot underestimate the risks of investing in bonds in this kind of environment.  The risks have been high and have remained high for several years now.  The effect of having these high risks for so long, with seemingly little consequence, has only numbed us all to the point many seem to believe no risks exist at all.

Every day I watch what I consider to be junk municipal bonds, even defaulted bonds, trade at levels similar to those for the highest credit rated bonds.  While it makes no sense, so far the end result has been the same: nothing different seems to happen to the junk bonds and they continue to be priced like top rated bonds.

Yet despite numerous situations in which one cannot seemingly tell the difference between high quality and junk-rated bonds, differences do exist and can be measured.  When one compares non-callable treasury bonds with those of non-callable lower-rated (or junk) bonds, one can see that over the past year, spreads have widened (source: Barclays US Corporate High Yield Option-Adjusted Spread).

Investors no longer believe that junk bonds should be more highly valued when compared to US Treasury bonds, for example.  In fact, investors have begun to move in the opposite direction, away from riskier bonds and back towards safety.

So not only are interest rates moving higher, but we also have spreads widening between lower-rated and higher-rated bonds.  This is important because both represent trend changes from the past several years and both show the market for bonds is changing and has changed despite the pundits’ fascination with Federal Reserve interest rate policy which so far has remained unchanged.

The Federal Reserve will raise interest rates and when it does it will be a follower of the market.  The question of when will the Federal Reserve is irrelevant; the question is whether the trend towards higher interest rates is real.  I believe it is.  Higher interest rates is the new trend and when combined with rising spreads between high quality and low quality bonds, I believe you have a trend that will develop into a devastating bear market for bonds.

Whether, or even when, the Federal Reserve chooses to raise interest rates does not enter into my forecast.  My assumption for the past several years has been that bond prices will peak and then the trend will reverse.  Both events have happened.  If we were investing in US Treasury bonds or corporate bonds our portfolio would have to change because a rising market and falling market would entail two distinctive, almost polar opposite, portfolios requiring a wholesale turnover of your portfolio.  This type of dramatic portfolio turnover is not occurring, I believe because very few investors recognize the risks their bond portfolio is putting them in.  The world, simply, is staying pat: fully invested in longer-term bonds despite the turn in interest rates and credit spreads.

Thankfully you are not dependent upon bond money managers’ decisions to hold pat.  You are not invested in a portfolio of US Treasuries or corporate bonds and your bond advisor isn’t waiting for a Federal Reserve announcement that interest rates are now rising.

I believe you are blessed to be an investor in the municipal bond market, a market that is the least generic bond market available for individual investors.  Higher interest rates do not affect all municipal bonds similarly.  Some municipal bond credits are improving as time progresses, while others continue to deteriorate.  Having tens of thousands of different municipal bond credits available is a huge benefit to us as investors.  We can continue to select bonds which we believe will continue to be worthwhile, and perhaps even more worthwhile, in a rising interest rate environment.

It continues to be the case that I am not recommending the purchase of the new issue municipal bond that is posted at the end of my monthly Letter.  We are looking for returns that are much better than these yields for their stated terms.  But we do know all these bonds listed below were indeed sold at these levels.  Somebody is buying these bonds at these levels and I rejoice that we have a choice not to.

I continue to believe the bond markets will be subject to tremendous volatility, price changes and liquidity issues.  Our strategy is to select bonds I believe have an ability to withstand these issues and perform in a manner that is worthwhile for us as investors of municipal bonds.  The Federal Reserve’s announcement may be a turning point for many participants in the bond markets, but we are not among them.  We have been prepared for trends now in place that others will only later recognize.