Posted on 12/07/2008 7:43:58 AM PST by TigerLikesRooster
Muni-bond funds face record losses
Some funds down more than 30%, opening door for bargain hunters
By Sam Mamudi, MarketWatch
Last update: 3:32 p.m. EST Dec. 5, 2008
NEW YORK (MarketWatch) -- Investors who think municipal bond funds are a safe bet in troubled times may be in for a shock this year, with some muni funds seeing losses of more than 30%.
With the stock market down more than 40% and Treasury bond yields at 50-year lows, municipal bonds can seem an attractive option. And while some managers see once-in-a-lifetime bargains in the muni market, several funds have cratered.
As of Dec. 4, there were 12 muni funds down more than 30% this year -- nine from OppenheimerFunds, two from Eaton Vance Corp. (EV) and one from Nuveen Investments.
"These are really extreme numbers," said Lawrence Jones, senior mutual fund analyst at investment researcher Morningstar Inc. "It's safe to say that muni funds have never seen losses like this."
The losses at the Oppenheimer funds make for painful reading.
(Excerpt) Read more at marketwatch.com ...
Ping!
How do municipal bond funds lose value, unless there are municipalities defaulting? Can anyone explain this to me in English?
The Bush legacy keeps growing, and he hasn’t even left office yet.
If investing in Munis people have to be very careful about the Issuer and the source of repayment. Even then, I don't see how the Fiscal mess can be resolved without a de-facto default in the form of devaluation of the currency through inflation.
i.e., there are no clear ‘Safe Havens’ IMO.
Oppenheimer Rochester Michigan Muni Fund (ORMIX) losing 38.6%
Oppenheimer California Municipal Fund (OPCAX) off 36.2%
Eaton Vance's High Yield Municipals (ETHYX) was down 34%
National Municipals (EVHMX) is down 32.6%.
Nuveen High Yield Municipal Bond (NHMAX) was down 33.7%
While they are still paying, the value of the bond goes down, because the perceived risk of default goes up.
If you bought individual bonds and held them to maturity, you wouldn’t care unless there was a default. But these funds trade continually, and often use leverage. The credit difficulties have driven up their cost of funds, and driven down the mark-to-market values of their portfolios.
People will always have reasons to sell in good times and bad, but buying can always be postponed.
So what we are seeing in the municipal bond market is an increased risk of default. Interest rates are rising dramatically as investors are demanding record levels of compensation for taking the risk that issuers will not default. So the price of outstanding municipal bonds are dropping taking the share price of the bond funds with them.
Separate from the above 2 factors, I suspect a lot of hedge funds are dumping assets including municipal bonds. This forced selling drives down bond prices. Think of it as a huge marginal call on the levered players. They have to sell their most marketable securities to raise cash and that can include municipal bonds.
For the record, I do not invest in municipal bonds. I follow 3 guiding principles in my fixed income investing: quality, quality, quality. That is why I only buy direct obligations of the US Treasury.
Mark to market accounting. In other words, the fund has to carry a bond’s value at what it would bring in the open market today.
They haven’t really lost anything if the bonds are all held to maturity but will if the fund is forced to sell bonds to pony up cash for those selling out of the fund. I doubt this will happen, though.
Same with the high yield corporate bond funds. They all have been hit with this accounting requirement.
CA is discussing paying suppliers with IOUs... It is bad out there in the states. They have not been good stewards of the tax money they take, and expect.
You write: “For the record, I do not invest in municipal bonds. I follow 3 guiding principles in my fixed income investing: quality, quality, quality. That is why I only buy direct obligations of the US Treasury.”
If I had followed that naive strategy for the last 30 plus years my retirement fund would be 1/5 what it is today, even after losing 30% this year. Don’t you lie awake at night wondering what you could have done with 5 times as much retirement money as you have after investing in treasuries?
If you own individual issues that you can hold to maturity then what you say is true. That is if you own a bond that is guaranteed to pay off at 100 cents on the dollar at maturity then you can ignore price changes while the bond is outstanding. In this case the only risk you run is re-investment risk, that is the risk that interest rates are unfavorable at the time the bond matures and you want to purchase a new one.
I appreciate your input, and I realized that I didn’t read the article after I posted my request for explanation. I subsequently went back and read the article and still didn’t understand what they were trying to say. There are several posts I response to my request for explanation that did a better job of explaining than the article did. In particular the one by Trek made sense to me.
For clarification, I have investments outside of the fixed income market. I am a firm believer in diversification across asset classes. My comments were addressed only to my view on investments in the bond market.
>That is why I only buy direct obligations of the US Treasury.<
Some relaxing, reading material for you to enjoy with your lunch.
http://www.financialsense.com/editorials/fekete/2008/1205.html
But facts are facts. And gold is trading today about where it was in the 1980s where it peaked at around $800/ounce. Factor in storage costs and the long-term "gold bugs" have been destroyed.
But circumstances can change. And as bad as things appear today anything is possible. Perhaps sound money will re-appear some day.
I try to keep my investment decisions and my political views separate. But I always have an open mind. If I thought gold needed a larger role in my portfolio I would certainly add some.
But for me, the bond market is primarily a source of current income. And this is different than a store of value. In deflationary times gold is going nowhere. And, right now, I see massive capital destruction all around us.
JOMO
The article says that Muni bond funds run by Vanguard, Fidelity and T. Rowe Price have largely avoided the problem.
I have money in T. Rowe Price’s Virginia tax-free muni fund (PRVAX) and in the last 12 months, it’s down 4.95%. I also have money in Vanguard’s Long-Term Tax-Exempt Adm (VWLUX) fund. It’s down 4.7% over the last 12 months.
Both of these funds yield is in the 4.5% to 4.7% range, tax free, corresponding to 6% or so depending on your tax bracket.
I’m OK with both these funds being down 5% and wish that the rest of my investments had done so well.
Jack
Multiply this simple case by hundreds, if not thousands, of similar bond purchases -- and you can see how a municipal bond fund works.
Now suppose a rating agency reduces the bond rating for the municipal government in our example from AAA to A. Every $10,000 bond it has issued will immediately lose a portion of its "market value" (even though it still has the same "face value") because it was issued as a AAA-rated bond (i.e., it pays a lower rate of interest because the risk of default was very low at the time) but the government that backs the bond is now considered only an A-rated risk (i.e., the risk of default is higher).
This is why astute bond investors over the years (Michael Milken, for example) never invested in AAA-rated bonds. Their ratings have nowhere to go but down, while the interest they pay will always be based on the original AAA rating.
I understand your "quality" approach (and agree with it), but does it make sense to do this when interest rates on U.S. Treasury securities are so low?
Why would anyone buy a 10-year T-bill that pays 2.75% (or somewhere in that range) when the U.S. government is taking on financial obligations that will almost certainly drive us into an inflationary climate in the next few years?
A typical long term municipal bond matures 20 to 30 years from now. Suppose it originally yielded 5% on the price --- that means the original buyer's deal was pay $1000 per bond now, and get in return $25 every six months for 20 or 30 years, then $1000 at the maturity date 20 or 30 years from now.
Now, suppose the rate this bond has to pay to investors to get them to hold it rather than some other investment rises to 7%. The payments promised haven't changed --- we call those the "cash flows". What does the first cash flow --- the amount paid --- need to be to yield 7% to maturity instead of 5%?
For a 30 year bond the answer is about $752 dollars, 75.2 percent of the face value. For a 20 year bond it is $788 dollars, or 78.8 percent of the face value. The lower price makes the yield to maturity higher, because you are buying those $25 coupons every 6 months for less than $1000, and also because the amount paid is (effectively) slowly appreciating to the full $1000 face value at maturity, and that slow climb adds to the overall yield. But only slightly, for a maturity date that far off in the future.
The relationship between the current price and a change in the yield is called a bond's *duration*. Technically, it is the first derivative of the price with respect to changes in the yield. It turns out it is also very close to the midpoint of the cash flows, in a (discounted) weighted-average sense. In the example above, the 20 year bond has a duration of about 11.5 and the 30 year bond has a duration of about 13.75. There are smaller, second order effects (having to do with reinvestment of the coupons, effectively) called "convexity", that can matter for very large changes in rates. In the example above, the 2% rate change doesn't quite cause a 11.5*2 = 23% fall in the price, only a 21.2% fall, for the 20 year, and doesn't quite cause a 13.75*2 = 27.5% fall for the 30 year, only 24.8%. Convexity makes the bigger change not quite as bad as twice the smaller change. We say, the relationship is a little better than linear in the interest rate.
That is technical detail. The main point is that a change in the rate on a long-dated claim can only be brought about by a large change in the initial price. What has happened to munis this year is that the rates on them rose, even as rates on treasuries fell. The rates on lower quality munis rose more than most. The rates on corporate bonds rose even more. When rates on worse credit risks rise while treasuries move the opposite way, we say credit *spreads* are *widening*. Lower confidence and higher expected loan losses cause that. So does a general shift in demand away from risky to safer bets, aka a loss of confidence.
The actual rate of muni bonds having payments run behind is only about 1.4%, and something is generally recovered even in those cases, so the loan losses might only run half that. Maybe they will rise to as much as 1% a year in the next year or three, but it is unlikely they will ever go much higher than that, or stay there for the whole life of such bonds. The higher rates at today prices will more than cover any actual losses, in other words.
Why have rates moved so much anyway? Competition, basically. There are lots of really cheap investment opportunities on offer these days, lots of them going begging. E.g. financial corporate bonds yielding over 10%, preferred stocks yielding up to 14%, leveraged loans yielding 15%, junk bonds yielding 20% etc. Well if someone is going to pass those by and pick munis instead, they need to get a competitive after tax return to choose the muni.
Why are all rates much higher? A lot of the people and capital that normally own this sort of stuff "blew out" over the last year --- meaning, lost all of their capital. They often borrow from banks to "carry" such investments, and when the prices of their assets fell, they were forced to sell at low prices to cover the cost of their bank loans. Sometimes they simply defaulted and their positions wound up back at the banks that lent to them. Who are trying to reduce their risks, not increase them. So a lot of these assets are being dumped on the market, banks won't lend to people to carry them anymore, or not on the same easy terms as in the past, etc.
Basically, it requires a whole capital structure taking credit risks to keep the prices of every tier of credit up at reasonable levels for the objective risks involved. Blow up that capital and prices just crater, without any relation to the objective credit risks. This does mean anyone buying in later at those lower prices and higher spreads is getting a bargain, objectively speaking. People who buy munis today are going to get higher returns over the long term future, than people who bought munis a few years ago.
The yield adjustment that brought that about, is this big price drop right now. Effectively, all the difference in return someone will get holding munis, comes in one big lump right now.
If there aren't any high credit losses, then a muni investor will gradually earn back that loss. Earning 2% higher for 20 or 30 years, he'll get back the recent loss and still get the yield he saw when he first bought the bonds. But it'll take that long.
One reason to buy shorter dates bonds is their price doesn't move as violently when interest rates change. The flip side of that is they don't rise in value as much, when rates fall. You pay your money and take your chances, on future interest rate movement. Personally, I think all the high rates now on offer for all categories of bonds besides the least risky treasuries, are extremely attractive. But your mileage may vary.
you sound like you’re writing the new high school textbooks.
/s
I don't just do this now that interest rates are low. This has been my policy on bond investing for many years. So, in fact, I have significant appreciation in my bond positions right now because, as you say, interest rates have dropped. But that is not the point.
Let me be clear. I do not trade in the bond market as a speculation on the direction of interest rates. I invest in the bond market to generate current income subject to the constraint of minimizing risk to principal.
So if you want to criticize my treasury only approach to the fixed income portion of my portfolio as too conservative that's fine. Guilty! I have other investments in my portfolio, not in the bond market, that give me exposure to risk and consequently growth.
Perhaps to further clarify the point, if I wanted to create a "bonds only" portfolio (as I was accused of earlier) I would include in that portfolio bonds other than treasuries.
Understood — I think your approach is sound re: U.S. Treasuries. I just wasn’t sure how this was reflected in a low-interest climate of a historic nature.
The second part of your post warrants comment as well. I definitely agree that the Treasury and the Fed are playing an extremely dangerous game. The unprecedented measures they are taking to increase liquidity (say like increasing the monetary base 30% last month!!!!!) risks massive inflation down the road if they are not able to remove this liquidity when the markets start to function again. What are the chances they will get this right? (Think the "Maestro" who was lauded as the greatest central banker of all time!).
Now therein lies an argument for the gold-bugs at least at some point in the future. But my personal approach to mitigating this risk has been to keep my maturities relatively short and include real return bonds (e.g. TIPS) in the portfolio, at least for the longer maturities.
In fact, I have suspected that this deflationary low-rate scenario is part of a well-orchestrated plan to entice foreign investors (think China and major oil-exporting countries) flee to long-term U.S. Treasuries as a safe haven in 2008-09, then have them lose their shirts in 2010 and beyond by inflating their debt holdings away.
Yeah, our economy is on its knees...What does President Hoover/Bush do? Nothing, he leaves it to the guy who isn’t even in office to try to calm the markets etc. Bush goes off to Peru-working on the legacy. I believe Pres. Bush is not an evil man; he is innately a good man, but he has been a horrible president in terms of domestic issues. He also helped elect the Democrats this year.
The first is that there is a belief that the bond will not be payed in full. That risk assesment is priced into the bond, and a bond will go up or down accordingly.
The second way a bond goes down is if interest rates in general are going up. If interest rates are going up, then the price of a bond will go down. If interest rates are going down then the bond price will go up. In this case, since interest rates are trending down, the municipal bonds are going down because of perceived risk.
“Payment Interruption”!!!! that’s the ticket there’s a payment interruption going on.....it’ll resume in about 15 years after the revolutions.
Maybe, but I don't see how the authorities can inflate their way out of this one. For example, a lot of the huge unfunded liabilities of the Federal government (e.g. Social Security) are automatically adjusted for inflation on an annual basis. And the borrowing needs of the country aren't going away next year. They are going to increase astronomically. And to further argue the point, if we can figure out the scam so can the Chinese. They may be inscrutable but they are not stupid.
No, while I love a good conspiracy theory, I don't think that's it here. On this one, the banksters got caught over-leveraged and they are screwed. And they are going to do everything in their power to stay whole including bankrupting the Treasury if need be. We may get a massive inflation, but it won't be by design.
Bottom line: are in a lot of trouble. And there are no easy policy answers, at least not ones that stand a snowball's chance in hell of being enacted.
W never did like dealing with economic issues, and now he has somebody to dump it on, while he goes off helping the people he really cares about, non-Americans.
Well said Moonman62 and very true. I voted for W twice.
Government will probably have to back their new bonds with their real estate holdings, like buildings and schools, in order to get people to buy.
From Wikipedia, re: German Inflation in the '20s:
The Rentenmark replaced the Papiermark. Due to the economic crises in Germany after the Great War there was no gold available to back the currency. Therefore the Rentenbank, which issued the Rentenmark, mortgaged land and industrial goods worth 3.2 billion Rentenmark to back the new currency. The Rentenmark was introduced at a rate 1 Rentenmark = 1:10 (to the 12th power) Papiermark, establishing an exchange rate of 1 United States dollar = 4.2 RM.
- snip - full story at their site
The Rentenbank continued to exist after 1924 and the notes and coins continued to circulate. The last Rentenmark notes were valid until 1948.
[Sidebar] - The Krauts may have inflated, but they owned up to their obligations. From Wikipedia:
In the year of von Lettow-Vorbeck’s death (commander of the German East Africa Army in WWI) , 1964, half a century after he arrived at Dar es Salaam, the West German Bundestag voted to fund the back pay for the Askaris [black German soldiers] still alive. A temporary cashier’s office was set up in Mwanza on Lake Victoria. Of the 350 old men who gathered, only a handful could produce the certificates that von Lettow had given them in 1918. Others presented pieces of their old uniforms as proof of service. The German banker who had brought the money came up with an idea. As each claimant stepped forward, he was handed a broom and ordered in German to perform the manual of arms. Not one man failed the test.
Is that Cool or what?.
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