The Motley Fool Discussion Boards
Investment Analysis Clubs / Macro Economic Trends and Risks
|Subject: Re: Municipal bonds: A train wreck waiting to ha||Date: 12/6/2012 9:11 PM|
|Author: yodaorange||Number: 410703 of 479664|
This post contains answers to Jgc123 and Crackdclaw.
Jgc123 asked: How do you research muni funds? My Dad has a chunk of PRVAX which provides tax free income at about 3.6% and I can't figure out how to research the relative risks of the individual holdings.
Jgc, I do not know of an easy way to answer this question. I went and downloaded the latest holdings in the fund. Unfortunately, they do NOT list the “CUSIP” for each bond. You have to find that yourself. I did that for several of the larger holdings and found that the bonds are callable early. For example one large holding is:
METROPOLITAN WASH D C ARPTS AUTH ARPT SYS REV AIRPORT SYS REV BDS
Callable at 10/1/20 @ 100
Currently Valued at 113.9
I would not attempt to judge whether this bond will be called in 2020 or not. If it is called, the fund will obviously lose the extra 19 years of a 5% yielding bond.
I do not know if Morningstar does this kind of analysis or not when they review a bond fund. I thought they mostly went off of past performance. Let me hypothesize two different funds
a) Muni fund A currently yields 4%, has a duration of 7 years and contains only bonds that are NOT callable. Credit quality = XYZ
b) Muni fund B currently yields 4%, has a duration of 7 years and contains only that ARE callable. Credit quality= XYZ
Even though the statistics are nominally the same, you would expect these two funds to perform differently due to the call/sink provisions. The reason for the difference is that duration changes as interest rate changes. A third factor called “convexity” is used to quantify this. If interest rates continue to fall, you would want to own fund A. It will perform better over the long term. If interest rates rise, fund B would likely perform better.
With enough time, you could be a model of how each fund would perform under different interest rate scenarios. Clearly beyond the scope of most of us.
In the particular case of this T Rowe Price fund, I would NOT worry about it. Those folks are very capable managers. They understand this stuff inside and out, far better than any of us can. Will this fund suffer it a lot of its bonds are called early: yes. My bigger concern is the small investor buying individual bonds as I will detail in the next section
Train wreck to Yechhh. I understand bonds are viewed as stable, low risk, income producing, widows & orphans type investment. I'm not understanding this potential disaster. A 1.66% return on a $10,000. investment today, that is cashed out in 2018, perhaps not what brought you to the buying table, but one can be hurt far worse with other investments.
With the headline of train wreck, I thought there was additional news on muni bond defaults. Am I misreading Sloan & Yoda? An investment today of $12,051. for a $10,000. bond and if (when) called in 5 years ends up returning ALL of your principal and a net yield of 1.66 over those 5 years? Call it Yechhh, but all in all, still some degree of safety vs other investments.
Crackd, I copied the headline wording from Allan Sloan, so it is not some Yoda invented hyperbole.
Whether it is a train wreck or not is in the eye of the beholder. Consider an investor that’s only source of income is muni bond interest. There are MANY real world folks like this or close enough to make it valid. This person has planned an income stream of 4.36% like Alan said. The investor actually receives an income stream of 1.66%. His income just dropped by 62%. I do NOT know many folks that can easily adapt to a 62% reduction in income ad infinitem. It is well documented that a large fraction of American’s do NOT have an extra $1,000 they could come up with on short order. Add a 62% drop in income to this culture and I think it is NOT a stretch to call it a train wreck.
Let me give you a specific real world example of bonds that are for sale today. So this is not a theoretical argument. Here are the details:
St. Marys Georgia Water Bonds
15 pieces ($15,000 offered for sale)
Coupon yield= 6.125%
Offering price= 109.507
Maturity date 7/1/18
Amount outstanding= $2.13 million
Amount called on 7/1/13= $300 k @ a price of 100 (aka “sunk”)
Odds of these 15 bonds being called on 7/1/13 = 300/2150 = 14%
Cash flow if called on 7/1/13
12/6/12 Buy 15 bonds= $16,837 (ignores commission, but includes prorated interest)
1/1/13 Interest payment= $459.38
7/1/13 Interest payment= $459.38
7/1/13 Principal payment= $15,000
Net loss= $917
Internal Rate of Return = NEGATIVE 9.91%
If this was an investment in a speculative equity, a 9.91% loss would NOT be a big deal. If this was part of what you thought was an ultraconservative muni bond portfolio that was counted on to feed the family: IT IS A TRAIN WRECK. If your 15 bonds do NOT get called in 2013, they have another 18% chance of being called in 2015 which will result in a loss.
|Copyright 1996-2015 trademark and the "Fool" logo is a trademark of The Motley Fool, Inc. Contact Us|