Setting the Record Straight on Municipal Bonds

A few weeks ago, 60 Minutes ran a segment on municipal bonds that featured a prediction by financial analyst Meredith Whitney of billions of dollars of defaults in the municipal market. When my MoneyWatch colleague Allan Roth examined whether municipal bonds were heading for a meltdown, many of his comments were right on target. However, a few weren't or need a more complete perspective. Let's take a look.

"Unlike the US Government, municipalities cannot print money."
While this is certainly true, basing the relative safety of U.S. government securities on the ability of the U.S. government to print money is a faulty premise. For all practical purposes, firing up the printing presses is a default. Historically, one of the primary reasons governments have printed money is to reduce the real value of outstanding debt.

"Swedroe stated his firm can trade with very small spreads, though I suspect he was only looking at part of the transaction before it was sold to the next investor."
First, anyone with an Internet connection or a Bloomberg terminal can analyze transaction costs in the municipal bond market. The simplest way to do this is to look at the inter-dealer price that the security traded at prior to your purchase and see how much more you paid. My firm typically pays about 0.10 percent to 0.20 percent more in price (not yield) than the inter-dealer price for municipal bonds. If the bond is held to maturity (as most of my firm's clients do), there's nothing more to consider. The total transaction cost is somewhere between 0.10 percent and 0.20 percent relative to the inter-dealer price. It's also worth noting that transaction costs in the municipal market are high for retail investors investing through brokers but, as the numbers above illustrate, they're much lower when experienced institutional investors are trading with brokers.

Also, when securities aren't held to maturity, my firm's experience is that trading costs on sells are very similar to the trading costs on buys. In addition, we have found that we can also do what are called cross-trades, where we have a broker-dealer act as the middleman between a buyer and a seller. In these cases, the only cost will be a nominal transaction fee of perhaps $50 to $75. Since we limit our holdings to only the highest investment grades and short-to-intermediate maturities, our clients typically hold similar bonds, making cross trades possible.

Finally, because some investors may need cash to meet unplanned expenses, we'll typically hold a small percentage of the portfolio in a money-market type account or a mutual fund, thereby avoiding the transaction costs.

"Buying bond funds eliminates liquidity risk as they can be sold at net asset value."
Using a bond fund doesn't magically eliminate transactions costs. Any time a security is sold in a bond fund (or any mutual fund), existing shareholders essentially pay those transaction costs. At the rate municipal bond fund redemptions are occurring right now -- with investors withdrawing more than $9 billion from municipal bond funds since November -- there's substantial exposure to transaction costs.

These costs can be especially high during bear markets when funds must sell to meet redemptions, but liquidity has left the market, causing trading costs to rise. Holding a portfolio of individual bonds avoids these costs.

"If Whitney is right about the number of defaults, I'd expect markets to become even more illiquid."
I completely agree here. When credit risk increases or markets become dislocated, liquidity will certainly be impaired. And as I noted, this is when trading costs for funds will increase, negatively impacting returns to investors.

"The argument of holding the bond to maturity will eliminate this interest rate risk is a myth."
I completely agree here as well. This is one of the biggest myths out there.

"Buy your bonds in low cost funds: Never buy individual bonds. You merely accept more default risk from lack of diversification, and liquidity risk from potential trades. Buy ultra low cost muni bond funds with hundreds of holdings such as those from Vanguard."
This comment just isn't true. While funds do help diversify issuer risk, most municipal bond funds roughly weight their holdings by market capitalization, so they end up holding riskier credits. And because default risk increases geometrically as you move down in credit rating, funds aren't likely reducing the risk of losses. Instead, they increase it relative to a strategy of avoiding those credits.

Let's use the S&P National AMT-Free Municipal Bond Fund (MUB) as an example. Currently, it has about 22.5 percent of its portfolio in California municipal bonds. Does anyone really believe this is reducing default risk as opposed to a simple strategy of completely excluding California municipal bonds (especially state general obligation bonds) from one's portfolio, limiting holdings to Aaa-rated and Aa-rated bonds and avoiding even highly rated bonds from sectors (such as health care and multifamily housing) with high historical default rates? In fact, this is a strategy my firm frequently pursues for investors who aren't California residents.

Or let's use an example from the corporate bond world to illustrate the point. Let's say I have a fund that has 500 holdings but only holds Aaa and Aa-rated credits. Does this fund have more or less risk than a fund has 1,000 holdings but also holds A-rated and Baa-rated credits? The answer should be obvious.

More on MoneyWatch:
How to Build a Bond Portfolio Do Municipal Bonds Still Have a Place? Vanguard Bond Funds Are Not All Created Equal For Bonds, Yield Doesn't Always Equal Return 16 Financial Resolutions for the New Year
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.