What? Municipals on Top?!

Happy New Year!  Municipal bonds were one of the best performing asset classes for 2015*.  That doesn’t happen often (ever?)!  Municipal bonds didn’t post stellar returns but compared to the sub-par performance of almost every other asset class, municipal bonds came out on top.

Obviously we don’t invest in municipal bonds because we think they will be the top performing asset class each year.  We like the income, particularly tax-free income.  Municipal bonds may not have the sex appeal of other, perhaps higher yielding investments but they also do not have some of the risks.  In this era of low (to no) interest rates we have seen others chasing yields in all kinds of asset classes from master limited partnerships (MLPs) to high yield junk bonds and even in higher dividend stocks.

2015 saw some investments for yield really take it on the chin.  According to The Alerian MLP Index, Master Limited Partnerships (MLPs) as an asset class lost about forty percent of their value last year.**  Forty percent is enough to whack off many years of projected income and price fluctuation is but one of the risks associated with MLPs.  Sure the yield (income) investors were hoping to grab is still there…unless the MLP cuts the dividend rate, another risk associated with MLPs.  No doubt MLPs performed well for many years prior to 2015, but then, bam, the trend moves in another direction leaving MLP investors to try and salvage their investment.

Bonds, most of them anyway, are usually of the fixed income variety.  The risk is not that the issuer cuts the income (coupon) rate (it’s fixed income), but rather the risk is that the issuer may not be able to pay the coupon (or later, the principal).  This is but one risk investors of high yield junk bonds (re)discovered in 2015.  Particularly seen in bonds of commodity companies such as oil and mining companies, the bond prices of these issuers fell and the yields increased (according to Morningstar, spreads in the energy sector widened almost 660 basis points in 2015; 650 for the mining sector).  Like investors in MLPs, high yield junk bond investors will still receive the lower yields they invested in (at the higher prices) but now these investors must contend with the new reality that perhaps their issues are not as strong as previously believed or if continued price declines for their bonds may be in order.

Additionally, the high yield junk bond market also reminded investors in 2015 of liquidity risk.  On the one hand, liquidity risk is just another form of market risk.  When prices of bonds slide, particularly below seventy cents on the dollar, the resultant yields cease to make much sense.  Tell me the difference in this market between fifteen percent yields and twenty percent yields, other than price and fear?  If the bids for high yield junk bonds are dropping quickly, the seller may balk and claim liquidity is disappearing.  To me this is market risk that rises up when fear increases.

However when you expect your mutual fund to liquidate your shares for cash and the mutual fund reneges, this is indeed liquidity risk.  Mutual fund investors expect to be able to redeem their shares for cash and the Third Avenue Value Fund recently reneged on this expectation.  This is a huge red flag and unfortunately, I believe, a harbinger of additional problems that all mutual fund investors may face.

Each of us as investors have certain assumptions we are making when we make an investment.  Some assumptions we consciously make and affirm each time we buy a new security.  Yes, I would like to invest in that four year bond issued by the state of California, for example.  But other assumptions are more unconscious perhaps, such as how we expect the next four years to be similar to the past four years, or when I give the order to liquidate, I will receive my funds the following day.

Reneging on the expectation of liquidity, to me, is a huge deal.  It is huge to me not because they reneged; indeed I expected this to happen, I just didn’t know when or with whom it would happen.  As many of you know, I do not go around thinking the next four years will be like the previous four years.  Things can and will happen.  Unexpected things can and will happen.  This is how markets work.  And just because prices are falling ten, twenty, thirty or even forty percent, that does not mean the markets are not working…contrary, it means they are!

Reneging on the expectation of liquidity is, in my opinion, a shot across the bow for all investors in mutual funds.  Just because the mutual fund manager doesn’t like the bid for  his (your) high yield bond junk bond doesn’t mean he should wave the white flag and quit.  The expectation of liquidity for mutual funds is now an open question.  This doesn’t change my opinion on mutual fund investing as I believe liquidity to be a risk in mutual fund investing.  Now, however, I am not alone in my farfetched assumption.

After 9/11 we discovered that everyday stock and bond transactions were subject to liquidity risk.  Markets normally open every business day were instead closed for many days following the attack.  Market prices were changing (I assume) but our ability to transact business was suspended.  I’m not arguing that 9/11 wasn’t a one-off; it most certainly was.  This wasn’t the only time I found the bond market essentially closed, though it might have been unusual for the stock market.

We have been very blessed to live through an age in which asset prices have trended higher and higher over many, many years.  This experience has shaped our investment philosophy as well as our assumptions for the future.  One side effect of this experience is believing that risks may be low or that some risks may be non-existent.  We do so at our own peril and certainly I believe that a large part of my job is to help steer us away from risks, seen and unforeseen.

My approach, The Select Approach, was designed to avoid many of the big risks discussed above as well as those I see looming in the future.  After decades of rising prices, we indeed live in a different age.  Prices are higher, yields (interest rates) are lower, and we have more debt than at any time in history.  This is not 1980.  This is not 1990.  This isn’t even 2000 though similarities exist.  No, we are decades down the road from the beginning of the greatest bull markets in stocks, bonds, well assets in general.  Yet these assets are all markets and yes, markets do fall and we should expect this and do all we can to avoid a falling market.

I have, and will continue, to bombard you with the realities of a falling market.  You did not want to be in Gold at $1900/ounce but a few years ago.  You did not want to be in Oil at over $100/barrel seemingly just the other day.  You did not want to own Puerto Rico bonds at 100 no matter how convinced one may be of their solvency…what solvency!  Markets turn and when they do it can become ugly fast.  Bam!  This is the lesson of those assets; this is the lesson of MLPs and high yield junk bonds for 2015.

So what about 2016?  If you guessed the trend is for more asset classes to join the price plunge, I’d say you are a trend follower.  When so-called rising trend markets are up only marginally while other asset classes are getting whacked, I’d say there is more risk to the downside than reward to the upside.  But of course that is just my opinion.  My job is to apprise you of the risks out there and continue to show you ways in which you can try to avoid the big risks while taking advantage of income opportunities in municipal bonds.  The risks have always been there and will continue to be there but we can continue to use municipal bonds to help manage the risks.

*iShares, Blackrock

**The Alerian MLP Index is the leading gauge of large- and mid-cap energy Master Limited Partnerships (MLPs). The float-adjusted, capitalization-weighted index, which includes 50 prominent companies and captures approximately 75% of available market capitalization, is disseminated real-time on a price-return basis (AMZ) and on a total-return basis (AMZX).