Views Differ on Odds of Bond Rout
Some municipal bond experts and investors are wondering whether history will repeat itself soon.
Their concern: A possible rerun of the bond market crash of last April and early May, when tax-season selling and sharply rising interest rates knocked 15% or more off the values of municipals and municipal bond mutual funds in one of the quickest, sharpest declines in years.
Some investors, still shellshocked, haven’t returned to the market, investment advisers say. Other investors wonder whether they should get out, at least for now.
“There’s a very good chance it could happen again,” says Ralph G. Norton, editor of Muni Bond Fund Report, a Huntington Beach newsletter that on Wednesday advised subscribers to dump long-term muni bond funds and go into safer, less volatile tax-free money market funds.
There are some indications that a decline may be starting already, Norton argues, although there’s no evidence yet that it will grow into a full-scale rout like last year. Interest rates have begun to rise following recent reports on unemployment and retail sales showing that the economy may be stronger than previously thought.
As a result, muni bond prices are down about 2% since peaking in mid-February, Norton says. (Bond prices fall when interest rates rise, and vice-versa.)
Norton adds that many of his clients plan to sell muni bond fund shares to raise cash for taxes due on April 15. This tax selling hits munis harder than many other securities, because tax-free bonds are held in large numbers by affluent individual investors, not institutions, Norton says. Many of these wealthier taxpayers face higher tax bills this year, thanks to tax reform and its crackdown on tax shelters.
Investor redemptions of shares in muni bond mutual funds were a major contributing factor to last year’s crash, because the funds had bought bonds heavily at that time and were low on cash. The redemptions thus forced many funds to sell bonds in their portfolios to raise cash to pay shareholders.
Another factor that could contribute to a selloff: Reduced liquidity in the muni market, thanks in part to the disappearance of commercial banks, which used to be traditional buyers of last resort until tax reform killed their tax breaks for buying municipals. Last year, without banks’ participation, market liquidity in the April decline dried up, adding to the free-fall in prices.
This year, Norton argues, liquidity has been cut further by the exit from the market of some major dealers, particularly Salomon Bros., formerly the biggest municipal bond dealer.
But others minimize the chances of a repeat of last year’s nose dive.
“It’s very unlikely,” says George D. Friedlander, managing director of municipal bond research at Smith Barney, Harris Upham & Co. “There could be modest selling pressure, but not much.”
One reason that any decline will be more orderly, if it comes at all, is that “investors have learned their lesson from last year,” Friedlander argues. Many investors bought long-term muni bond funds before last year’s panic, thinking the shares would be easy to sell quickly and avoid a drop in prices, he says. They were wrong, and consequently many are no longer investors in such funds, he says.
Less Emphasis on Munis
Dealers also are carrying much lower inventories of bonds than last year and thus have more capability to buy if prices fall, Friedlander argues. Last year, dealers were overloaded with inventories, having bought heavily in a battle for market share. They were not in a position to buy when the selloff started, he says.
Also, investors are more diversified in different types of bond mutual funds than last year. Last year, the market was dominated by open-ended funds, the type that often must sell bonds to raise cash to pay investors who want their money back.
But this year, proportionally more money is in unit trusts and closed-end funds investing in munis. Both of these types of funds have a fixed number of shares and thus don’t have to unload bonds in their portfolios when investors sell shares. (Instead, the price of shares fall).
Also this year, bond-fund portfolio managers are more prepared. Some are holding more cash and actively traded bonds that can be sold quickly, providing a cushion if there is a surge of redemptions from panicky shareholders. Funds also have lines of credit to raise cash.
“They will be in a much better position to meet demand of investors who need to pay Uncle Sam on April 15,” says Neal H. Attermann, manager of municipal bond research at Kidder, Peabody & Co. He adds that if a repeat of last year occurs, “it’s going to take another factor to get it going,” such as statistics on the trade deficit or inflation that show that interest rates may rise.
Zane B. Mann, publisher of the California Municipal Bond Advisor, a Palm Springs newsletter, contends that April will be a good month for municipal bonds and that prices may in fact go up.
He says interest rates will stabilize instead of rising, and taxpayers facing higher tax bills may buy tax-exempt bonds and sell stock funds or taxable bond funds to raise cash.
What to do?
Friedlander and others skeptical of a repeat of last year’s rout urge investors to stay put. Any decline, if one comes at all, will be modest and easily absorbed by a long-term investor, they argue. But if you need to sell for tax purposes, do so now, Friedlander suggests. But also look for buying opportunities later.
Norton, however, urges investors to switch, at least for now, out of long-term muni bond funds into tax-free money market funds, which invest in the shortest-term municipals and thus have little or no risk of loss of principal. Tax-free money funds with recent strong records that he recommends include Vanguard Municipal Bond Fund-Money Market Portfolio, USAA Tax-Exempt Money Market Fund and Fidelity Tax-Exempt Money Market Trust.
