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Headlining bankruptcies don't affect muni performance

This year we have seen a fair share of headlines highlighting significant defaults on the municipal bonds of such cities as Detroit, Stockton, and San Bernadino. For many investors defaults such as these brought back memories of the Dec. 19, 2010, forecast by Meredith Whitney. Appearing on "60 Minutes," she predicted that a tidal wave of defaults would occur in the municipal bond market in 2011: "You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."

Whitney's forecast shook investors and led to a record setting outflow from municipal bond funds.

Given the scary headlines, which have led many investors to flee or avoid the municipal bond market, I thought it worthwhile to review the performance of municipal bonds since Whitney's infamous forecast and compare them to the returns of Treasury bonds.

Munis vs. treasuries

We begin by comparing the returns of the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX), with an average duration of 5.4 years, with the returns of the Vanguard Intermediate-Term Treasury Fund (VFITX), with an average duration of 5.2 years. Keep in mind that the returns are total returns and are pre-tax returns. Data is from Morningstar.

Overcoming the headline defaults, the total return of VWITX since 2011 was 14.2 percent, outperforming VFITX's total return of 11 percent by 3.2 percent. And this is even before considering the impact of taxes.

We now compare the returns of the Vanguard Limited-Term Tax-Exempt Fund (VMLTX), with an average duration of 2.4 years, with the returns of the Vanguard Short-Term Treasury Fund (VFISX) with an average duration of 2.2 years.

We see similar results here with VMLTX providing a total return of 6.1 percent, outperforming VFISX's total return of 3.2 percent by 2.9 percent. Again, this is even before considering the impact of taxes.

Taking action

While there have been some significant defaults, the massive scale of problems that Ms. Whitney had anticipated didn't occur because governments have taken actions to address the problem, cutting spending and raising revenues. Unlike the federal government, all states except one, Vermont, are required to balance their budgets. As a result, budget gaps are being closed by layoffs of public employees, greatly reduced services, and increased taxes and fees. As a result there was a dramatic decrease in the budget gaps. From 2009 through 2012, the gaps were closed by well over $400 billion.

The closing of budget gaps, and the reluctance of the public to approve new debt issuance, has also meant that new bond issuance has shrunk dramatically. Reduced supply is a positive for investors. Through November, long-term issuance has fallen 15 percent this year. Additionally, the sharp drop in rates has allowed many municipalities to refinance higher rate debt, further closing budget gaps. The net effect is that the level of issuance in 2013 hasn't been sufficient to offset the calls and maturities this year, leaving the market with net negative new issuance.

All of this has been good news for municipal bond investors. Further good news was received when U.S. Bankruptcy Court Judge Steven W. Rhodes accepted Detroit's petition, enabling it to seek protection under Chapter 9 of the U.S. bankruptcy code. He ruled Detroit may legally reduce public pension benefits, despite protection of public pensions under Michigan's constitution. Rhodes' ruling has positive implications for municipal bond holders across the country.

Even Illinois, the state with by far the worst situation, finally managed to take some positive steps to address their long-term pension obligation problem -- though nowhere near enough, so Illinois bonds are still quite questionable.  

Keep calm and ignore the forecasts

There are two important lessons for you to take from this tale. The first is to remember Warren Buffett's admonish to ignore all forecasts because they tell you nothing about where the market is going. The second is to avoid the mistake Ms. Whitney made of engaging in stage-one thinking. Ms. Whitney, along with many investors, saw a crisis developing in municipal budgets, and the risks, but failed to see beyond that. On the other hand, those that engage in stage two thinking know that while there's no certainty, they do expect that a crisis will lead governments (and central bankers) to come up with solutions to address the problem. And the worse the crisis gets, the more likely they are to act with urgency and scale. That insight allows them to see beyond the crisis (enabling them to keep control over their stomach and their emotions). As we noted above, governments took dramatic actions to address their budget problems, and the disaster Whitney predicted didn't occur.

Stage-one thinking leads investors to engage in behavior that is destructive to their portfolios. It results in what Carl Richards called the behavior gap -- the well known tendency for investors to earn returns well below those of the very funds in which they invest as they buy after periods of good performance and sell after periods of poor performance. The ability to engage in stage-two thinking, along with disciplined rebalancing, will help you avoid creating your own behavior gap.

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