Last Updated Aug 25, 2011 10:34 AM EDT
Remember that the goal of the investor's bond portfolio is to act as a shock absorber when equities plummet, as they did in in 2008 and are threatening to do again. The last thing you would want is to have your bonds handcuffed to the performance of the stock market when your stocks tank.
Why the fate of munis and stocks are now tied together
States and municipalities have huge liabilities facing them over the next few decades from their legacy pension plans. By some estimates, these unfunded liabilities reach three trillion dollars. In order to eventually pay these liabilities, their pension investments must yield high returns. And to get those high returns, they must be heavily invested in stocks and other risky investments. Here's an example.
Let's say the the City of Whitney, California, has pension assets of $750 million but the present value of its pension liabilities is $1 billion. It is 75% funded and must invest somewhat aggressively to have any hope of meeting its liabilities. The actuaries say it must earn eight percent annually to meet its obligations so the plan decides to invest 70 percent of its assets in stocks.
Now if we enter a great decade-long bull market, all will be peachy and Whitney will be able to meet its obligations. Under that scenario, which is quite plausible, I would probably regret that I didn't have some muni bonds.
But under the opposite scenario, where stocks lose 50 percent of their value over the next ten years, the consequences would be catastrophic for the City of Whitney. Such circumstances would have them paying out benefits while the value of the pension assets plummet. This scenario makes the possibility of default a reality and not just for Whitney, California.
In the stocks-do-poorly scenario, your muni bonds could then experience massive defaults. What this would mean to investors, is that when they really needed their money to be safe, it wouldn't be.
This time it's different
US Government bonds have traditionally been the safest, followed by high-grade munis, with high-grade corporate being third. High grade corporate bonds, however, don't have this same unfunded pension liabilities because they converted to defined contribution plans years ago.
Now I'm not saying that corporate bonds are less risky than munis, but rather that the fate of munis is now more risky since they have become more tethered to stock market performance than ever before.
I get my stock market exposure from stock index funds and want my bonds to be there when I need them. That's why I just sold the very little exposure to munis that I had. I want the performance of my fixed income to be as independent as possible from the performance of the stock market. It's that plain and simple in my book.
Thus nearly all of my fixed income is backed by the US Government. I search for the highest CDs with easy early withdrawal penalties and locate them in my tax-deferred accounts whenever possible. If my stocks tank, my funds will be there as long as the US Government doesn't default. I recommend the same to most of my clients and only use low cost muni bond funds sparingly.
note: image from SurvivingCalifornia.wordpress.com
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