The Mood of Municipal Bonds

When one thinks of municipal bonds, generally the next thought is…boring.  Bonds are usually boring; adding municipal to the mix should make them more so.  Bonds have a job to do and for most of the past several decades they have performed.  Primarily we have the trend to thank.

Many years ago bonds did only one thing: they got cheaper, seemingly, every day.  Interest rates rose in the 1950s, 1960s and by the time we got to the 1970s interest rates really rose.  Rising rates meant bond prices were sinking and therefore the goal of bond dealers was to get the bonds off of their books and into customers portfolios as quickly as possible.

Bond underwriters created new bonds, priced them attractively to get them quickly sold and pity the client that might want to (or need to) sell early. Selling usually meant taking a discount, or a loss of principal.  The best thing that usually happened after a bond was purchased was for it to mature, so the proceeds could then be reinvested at the higher interest rates of the day.

The bond market changed dramatically in the early 1980s as the trend of rising rates became the trend of lower rates.  But after decades of rising rates investors were slow to realize the trend had changed.  Looking back, everyone can now claim to have seen the trend change.  But for most investors it would take many years before they trusted the bond market with their investments.

Recently, Thanksgiving 2012, I believe we witnessed a momentous change in the bond markets.  After nearly thirty years of lower interest rates and higher bond prices, I believe the trend is now the opposite: higher interest rates and lower bond prices.  The implications of a trend change are huge and the impact, I believe, will be nothing short of dramatic.

In the early 1980s bonds were seemingly a sucker’s bet as they did nothing but decrease in price until the bond became very close to maturity.  Therefore, investors were not heavily invested in bonds and instead looked to the money markets and the up-and-coming money market mutual funds that paid over 7% and later over 10% interest.  As rates began to fall when the trend changed, investors didn’t lose, except for the opportunity cost of NOT being invested in long-term bonds.

Today we have almost the opposite extreme.  Investors own all of the long-term bonds (by definition) AND there is an exponentially greater amount of them.  One could easily say investors are “All in” with respect to bonds.  Just ask the Bond King, Bill Gross and the entire bond management industry that has been created and built over the past thirty years.

So rather than losing simply the opportunity cost of not owning bonds that described the situation in the early 1980s, today’s bond investors are on the precipice of tremendous, real losses.  Much of today’s asset pricing rational relies on stable (shall we say boring) bond prices.  Often times it is investors’ willingness to pay these boring (albeit high) prices because investors believe there are numerous others that are willing to pay these boring, high prices.  In a trend change however, these dynamics disappear…quickly.

In order to adapt to a new trend change, one has to suspend reasoning.  One must not ask why; it only is.  When I marked Thanksgiving 2012 as the date for trend change in the municipal market, very few people if any were also recognizing the date as significant.  Treasury bond prices had bottomed earlier in 2012 and by the end of 2013 the interest rate on the ten year treasury had gone from 1.38% to 3.03%.

There was no reason rates bottomed in 2012 but we can always go back and create a narrative to explain it.  This is how we acted in 1982 as well.  We can always write the story later; the important thing is that our investment portfolio is in synch with the new trend change.

No trend moves in a straight line.  So far this year we have seen the ten year treasury yield move lower, from about 3% to 2.40%.  The initial municipal bond sell off culminated earlier in 2013 and interest rates on municipal bonds have also moved down since then.  To simplify, we’ve seen a strong push up in interest rates and now we have seen a downward correction of that move.

From a long-term historic perspective, one could easily argue that nothing has changed lately and the historic thirty year bull market in bonds is intact.  Just remember, I don’t need to prove it to you (that the trend change has occurred) any more than I could have proven it to you back in the early 1980s or even in the early 1990s for that matter.

Dramatic change in the bond markets will occur if ten year treasury yields move beyond 3% again.  For trend change to occur interest rates obviously need to move higher and the reason this will happen is…well again, there need not be a reason.

Our municipal bond strategy over the past several years has a framing principal: municipal bond interest rates will rise.  Your municipal bond portfolio turns into cash on a regular basis by design and that design is not because we like investing in lower interest rates.  Your portfolio turns into cash regularly because we usually achieve the results we are looking for from the municipal bonds we buy.

There has been little change so far in many things, municipal bond interest rates included.  We have been lulled into complacency that things won’t change much, prices are seemingly always firm and the trend is your friend.  This will not last.  The trend in municipal bonds is now eighteen months old and for treasury bonds it will soon enter its third year.  I am expecting tremendous change going forward.