Muni bonds

So I was catching up with my parents this past week - they live in the States so I only see them every 12 months or so. Their financial advisor has invested 25% of their portfolio in Californian municipal bonds, which I’m not overly impressed with. I figure the risk of default is too high for a retired couple in their 60’s. I’d be interested in hearing some thoughts on the prospects of muni bonds (also, given interest rates are all but zero, it seems to me that this is a lousy time to be in bonds…)

newsuper Wrote: ------------------------------------------------------- > (also, given interest > rates are all but zero, it seems to me that this > is a lousy time to be in bonds…) That is irrelevant. Prices move on expectations of interest rate changes. Prices can still go up if rates go up slower than what the market expects.

Newsuper, I agree that’s a pretty high concentration in CA. They are a large issuer, but still. I work in risk and our group has been reviewing muni exposures a lot these past 6 months, it’s pretty difficult to really judge the risk accurately. For instance, bonds with guaranteed wrappers driving their ratings face rollover risk, not to mention many of the guarantors are not equiped to handle a large scale muni crisis, however, noone can really judge whether a crisis will occur as this hinges on the us economy and whether or not the fed govt steps in which would basically nullify any crisis. You also have to look at what proportion are general obligation bonds versus issuer specific bonds remote from their state or municipality (such as a sewer bond). Complicating this is the fact that most wrapped bonds lack underlying ratings and reporting is VERY spotty. In my mind, the lack of clear reporting standards is the biggest risk in the whole picture. Overall, I don’t know what to tell you, the whole picture is very clouded and it could easily be very bad, or there could be no crisis whatsoever, just as easily. The current positive economic signs give some hope for a less negative outcome, but I do think some stress will surface. To put it into perspective, a Berkshire firm, genworth got into the muni guarantee business several years ago, then completely exited in 18 months with Buffet basically saying what I said about a wide range of unpredictable outcomes an that the muni guarantor industry is “dangerous business”. Also worth noting is that AGM is the last remaining large muni guarantor with an investment grade rating after RMBS meltdown and they are facing further downgrades as S&P is reviewing their rating methodology with regard to capital adequacy.

I am skeptical that the yield chasing many folks seem to be doing is justified from a risk/return tradeoff perspective, and I think munis are a good example of this. David Swensen takes the view in his book “Pioneering Portfolio Management . . .” that no fixed income instruments other than Treasuries have a place in a well-constructed portfolio for this reason (i.e., probabilistically return doesn’t justify the risk). I’d think 25% in a diversified group of munis seems high; I can’t imagine any good reason to have all 25% in CA munis.

^probably for tax reasons

Black Swann made some great points. I work in AM firm that specializes in munis. Its pretty common knowledge that CA, IL, NY, NJ are not exactly in the best shape. However over the past couple month both CA and IL made significant strides in cutting down their budget deficit. Just to name a few, IL increased tax, and CA plan on cutting down expense on public services. But these news are over-shadowed by all the negative headline by the media, in particularly Meredith Whitney in “60 Minute”. As a result of the negative headlines ppl begin to withdraw money from the muni market. The yield on the muni bonds are fairly attractive right now because on the low demand. Often times you will find muni bond have higher yields than corporate bonds. This is very attractive because not only does muni bond provides tax benefit but also (despite all the negative news) they have lower default risk comparing to corporate bonds. On the contrary, if you are trying to sell the muni bonds in your portfolio right now, chances are you will get ripped off by a really low bid. As for having 25% in CA bonds, it depends on variety of factors. It is understandable if your parents are CA resident, because CA bonds provides them with state tax benefit as well. Like Black Swann mention another factor is how are the bonds secured. In CA case, general obligation might not be as safe as bonds that are secured by Water&Sewer Revenue. Our firm’s main goal is provide capital preservation for our clients, so we generally try to stay away from CA bonds, (even thought it might provide great value) because our clients are extremely risk adverse.

You do know that municipalities cannot default on their bonds, right? Munis have been on a tear lately coming back from their slump since the end of the BAB program (I do not think the Meridith Whitney had much to do with it, IMO). Now there is word that there is a push to bring back the Build America Bonds program, so prices have been rising as more demand is anticipated for municipalities with the program. Do not assume that munis will be allowed to default this is a long ways away IF it ever happens, at which point I am sure your parents FA would reevaluate their portfolio.

^ edit this post Munis can default, states cannot my mistake in reading your post. To monitor Build America Bonds see ticker BAB it yields 6% and is a good proxy of these bonds.

Yah, I was going to say, several munis already have defaulted. Also, I generally agree with impulse and he is obviously familiar with the market. The only thing I’d disagree with is default risk versus corporates. People saying it is lower are citing historical default rates. While the historical trend may possibly hold true over the next several years, we could just as easily see a departure from the past if we enter an unprecidented municipal crisis. Another reason I disagree on the default risk is that a) corporates have just emerged from a crisis, with strong, rebuilt/ delevered balance sheets, whereas munis are just entering their crisis and possibly have the worst balance sheet positions in their history. And b)the municipal guarantor model is in a precarious state, meaning cost of debt may climb for municipal issuers in the future, and investors may be relying on a bad guarantee.

Yeah they are CA residents, so I can see how it provides them with additional tax benefits. I appreciate your comments guys. It seems to me the main problem perhaps is not the presence of CA muni bonds in their portfolio, but more the fact that their FA has allocated 25% of the portfolio to them. I’ll need to dig a bit deeper and see if they are GO bonds or revenue bonds.

As an aside, I’m not overly impressed by the work of their FA (someone at Wauchovia), besides the 25% allocation to munis, there’s about 90 individual stocks and 25 open-ended funds (though the 25 funds in total make up around 3% of the portfolio - just weird). I thought it was common knowledge that diversification benefits were pretty much lost above 40 or so stocks? I’m tempted to email their FA with my views and see what he says.

I’d be careful in the email, try to keep it positive / constructive and ask for his views rather than going on the offense, you’re more likely to get a dialogue going this way. Although, expect some irritability as I’m sure he’s getting a lot of these emails lately.

Black Swan Wrote: ------------------------------------------------------- > I’d be careful in the email, try to keep it > positive / constructive and ask for his views > rather than going on the offense, you’re more > likely to get a dialogue going this way. > Although, expect some irritability as I’m sure > he’s getting a lot of these emails lately. No I would certainly try and keep it positive - I can only imagine what he thinks when the son of a client starts badgering him about the portfolio (I have been there myself), though to be fair the ‘son’ is not often a FA himself (or 6 months work experience from the charter - can’t wait).

I’ll have more to say about the portfolio, but if I were you I’d talk to your parents about any concerns you have and then let them deal with the FA if they want to (perhaps with you involved) - I don’t see any benefit to you contacting him directly, unless your parents just tell you to entirely handle it for them, and it might be counterproductive.

Captain Windjammer Wrote: ------------------------------------------------------- > I’ll have more to say about the portfolio, but if > I were you I’d talk to your parents about any > concerns you have and then let them deal with the > FA if they want to (perhaps with you involved) - I > don’t see any benefit to you contacting him > directly, unless your parents just tell you to > entirely handle it for them, and it might be > counterproductive. Good point. Though the problem is that they are pretty much your standard retail client: - they’re with this particular FA because a friend told them too (i.e no research) - I asked them what fees they were paying and they said “don’t know” It would be very easy for their FA to give them the mushroom treatment.

Yeah no kidding. It doesn’t sound like a very good portfolio to me (no offense to your parents of course); maybe you should encourage them to consider looking around for another advisor.