A Buy and Hold World

The municipal bond market is not so much of a market as it is a distribution scheme. Each week new issues of municipal bonds are sold, or distributed, to buyers looking for bonds like these offered. The bonds may disappear immediately or usually they are all distributed to buyers over several weeks.

The end result is the bonds are distributed. We can’t control whether or not any bonds are later offered or enter the marketplace. Last month I wrote that it only takes one: one bond coming back into the marketplace that may prove to be worthwhile for us.

This means the bulk of all municipal bonds are bought and held. With long-term bond yields trending down for thirty-plus years (and prices trending higher), a buy and hold strategy has been a winning strategy.

Yet somehow, someway, bonds come into the marketplace each and every day in an attempt to be redistributed. Thankfully not every bond holder buy and holds, so at least we get an opportunity to see if the bonds they are selling are worth buying.

The municipal marketplace is made up of tens of thousands of different credits and maturities. Long-term bonds become shorter-term bonds. Junky credits may become quite worthwhile; worthwhile credits may become junky.

I don’t know why someone owns Puerto Rico bonds, but so far I haven’t seen the value. The same can be said for the city of Chicago or its schools. Wading through, or slogging through the daily lists of junky, declining credits makes up a fair percentage of municipal bonds looking to be redistributed on a daily basis.

In such a buy and hold world, redistributing junky credits makes a worthwhile business model for dealers looking for something to do in the municipal marketplace. Sellers are often times motivated, but buyers are opportunistic as well.

Sometimes, these junky municipal bonds are insured. Some municipal credits started out worthwhile and most worthwhile credits prior to financial crisis were insured by municipal bond insurers. Usually after continuing to issue massive amounts of debt, or market recognition of unfunded liabilities (usually pensions and healthcare) these insured municipal bonds became insured junk municipal bonds. Fallen angels as they were.

I do not buy hospital bonds. I am married to a former hospital accountant. Hospital accounting is probably an oxymoron. My feeling is they may go poof in the night any night. I do not need that kind of risk, you do not need that type of risk, especially when tens of thousands of other options exist.

Fallen angels are like hospital bonds. Every one of them pays until the day they do not. Which municipal bonds will be the next Puerto Rico…Chicago, Chicago schools…I don’t care because they are to be avoided. Throw municipal bond insurance into the mix and what do you really have? The same thing… a junky municipal bond that may pay until it does not. Life is too short and we have lots of other choices, once we slog through the daily parade of junky municipal bonds.

Municipal bonds are bought for income and herein lies the good and the bad news. The good news is that all municipal bonds begin their life as paying, some until they mature, and some select few pay only until they do not. Investors buy these bonds for income. Because of this fact, most junky bonds do not trade at much of a discount; some even trade at a premium.

I’m as opportunistic as other municipal bond investors, but junky municipal bonds tend to look similar in price to worthwhile municipal bonds. Those that do sell begin to sell at discounts tend to later sell at greater discounts, an awful reason to speculate.

The stock market continues the rally begun last summer, nearing the end of an advance that began in 2009. Bonds, like stocks, are near their historic highs in price, as well, which may partially explain, why junky municipal bonds sell at premiums. Investors are underestimating risk. What risk?

Now is not the time to be complacent, especially with respect to risk. We remain ever vigilant, continuing to slog past hospital bonds and other junky municipal bond credits that may go poof-in-the-night.

We are thankful we have options each and every day and we will continue to cull the daily pile to find the items we believe to be worthwhile for the months and years ahead.