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Due diligence seemingly takes a backseat because of the demand to buy and own more and more bonds.

Over The Top

May 16th, 2016 by Kurt L. Smith
  • For the past several months we have discussed the manic moves of municipal bonds. As one of the best performing asset classes last year, it looked like we would be poised to experience follow-through this year with additional new money flowing into municipal bonds.

    Indeed this has been the case. Money flows into tax free municipal bond funds continues week after week. Not only are new deals like the one’s presented at the bottom of each month’s newsletter selling well in the marketplace, we are also seeing intense competition for bonds in the secondary market. In a word, the market in my opinion is “hot”. But after several months of “hot”, the market seems to me to be “over the top”.

    In a manic market such as this, assumptions are stretched and hope for the future becomes a certain reality today. Many of these assumptions surround price, which for a bond, is the same thing as assumptions surrounding yield. In a manic market, prices are high so yields are low. In a low yield world assumptions can be stretched beyond belief and often are. Due diligence seemingly takes a backseat because of the demand to buy and own more and more bonds. This would be a problem for us if (a big IF) these were the only municipal bonds available. 

    If German sovereign bonds under ten years to maturity were all selling at extremely high prices and negative yields, then you must accept buying short German bonds at negative yields. Same goes for Swiss franc bonds or even some high grade corporate bonds. If that is the price, then you must pay it to own that particular asset class.

    Thankfully municipal bonds do not all work this way. Rather than trading on a generic basis (“all German sovereign bonds under ten years to maturity, trade at negative yields”, for example), municipal bonds may trade uniquely. The operative word, of course is ‘may’ and this is an important distinction.

    In today’s manic market, the tendency is for all bonds to trade at high prices, certainly higher than a few months back or ever higher than normal. After all, manic is manic and we would therefore expect this. The danger of course is that the manic description may not apply to some municipal bond credits. Take Puerto Rico for example.

    Over the past few months the situation in Puerto Rico has not improved. Indeed prices continue to swoon this year and now actual defaults (May 1st) have occurred and will most likely occur again (June 1st). This has occurred despite a manic market for municipal bonds in general. My contention would be Puerto Rico bonds would be down more significantly in price had we not been currently experiencing a manic market.

    Municipal bond investor hope is high, even in Puerto Rico. Municipal bond investor hope is high in Chicago and Chicago schools. My impression is that municipal bond investor hope is high everywhere even in cases in which (my) due diligence says it is unwarranted and money will be lost.

    This is normal market action; manic phases happen. While it doesn’t occur often, I certainly can recall several instances over my thirty year career in  municipal bonds. Identifying a manic municipal bond market is important because it gives us context for how the rest of the world views municipal bonds investments.

    First, congratulations (again) on being so smart as to invest in this top performing asset class. The world will/is pumping us up with positive articles full of hope for the future of municipal bonds and certainly hope for even our troubled names; Puerto Rico, Chicago and Chicago schools to name but three.

    Second, every mania turns…usually swiftly and ugly. All the showing press currently full of hope will turn (inevitably) to despair. Again, this is normal market behavior. Boons beget busts and while I probably have to add “in my opinion” for compliance purposes, the statement is about as factual as one can make in the investment realm.

    Puerto Rico won’t default; Puerto Rico has defaulted. Billions of dollars have been lost; disappearing from brokerage statements across the country. In my opinion it will never reappear. It is gone and the money disappeared in a municipal bond investment.

    The assumption that municipal bonds have no risk, or even little risk, is an assumption that gets short shrift in a manic market such as the one we are currently experiencing. Thankfully Puerto Rico bonds at least now reflect some of their risk in significantly lower (low) market price for their bonds. Three  years ago this was not the case. Puerto Rico is not a unique situation, any more than Detroit was unique, or Stockton, or San Bernardino. Municipalities without the wherewithal to repay their tremendous debts will not go to extraordinary lengths to do so. In fact, the opposite may occur and they won’t pay.

    I find it highly credible and likely that today’s manic market is covering up many Puerto Rico’s three years hence. Where are these credits: they are the same as we have been watching since the last manic municipal market in 2006. Just because the market is manic, doesn’t mean the risks are lower; it merely means investors are choosing not to see them.

    Enjoy the good news on municipal bonds now. We continue to find worthwhile bonds. And when the manic market takes a dive and hope becomes despair, please know we will continue to find worthwhile bonds. Having context helps us navigate manic markets as well as desperate markets.

    Arlington, Texas Refunding

    Moody Aa1, S&P AAA, Fitch AAA

    Due 8/15 Dated 5/1/16 Maturity: 8/15/2036

    Sale Amount: $34,440,000

    1 2017 2.00% 0.63%
    2 2018 2.00% 0.74%
    3 2019 2.00% 0.87%
    4 2020 3.00% 0.99%
    5 2021 3.00% 1.12%
    6 2022 3.00% 1.25%
    7 2023 3.00% 1.40%
    8 2024 3.00% 1.52%
    9 2025 3.00% 1.67%
    10 2026 3.00% 1.81%
    11 2027** 3.00% 2.01%
    12 2028** 3.00% 2.19%
    13 2029** 3.00% 2.31%
    14 2030** 3.00% 2.45%
    15 2031** 3.00% 2.60%
    16 2032** 3.00% 2.70%
    17 2033** 3.00% 2.80%
    18 2034** 3.00% 2.90%
    20 2036** 3.00% 3.00%

      *Yield to Worst (Call or Maturity) **Par Call: 8/15/2026

    Source: Bloomberg

    This is an example of a new issue priced the week of 5/10/16

    Prices, yields and availability subject to change


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