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Author: yodaorange Big red star, 1000 posts Feste Award Nominee! Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 455314  
Subject: Municipal bonds: A train wreck waiting to happen Date: 12/6/2012 12:29 AM
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Every financial writer or blogger has a certain style and characteristic that you pick up on after a while. Many METARites are the same. If you read a METAR posting without knowing the author, you would probably be able to correctly guess the author in many cases.

When you read a blog or article, it helps to keep in mind the style and biases that the author has. And yes, try as we may, everyone has biases, including Yoda. Your goal might be Switzerland, but you end up being Russia.

When you read an “alarmist” article from a normally reserved author, you probably pay more attention to it. I read just such an article today from Allan Sloan. Allan has been around the block many times over his 30+ year career in finance. He is currently senior editor at Fortune. I have been reading his articles for a long time. He is NOT prone to hyperbole. If anything, he tends to err on the understated, reserved side. If Allan screams “fire” I am heading out of the theater ASAP.

Today Allan screamed fire about the muni bond market with an article: Municipal bonds: A train wreck waiting to happen. [1]

The essence of Allan’s argument is that muni bond buyers often ignore the call provisions in muni bonds. In many cases, they see a high yield and think it will persist until the bond matures. What they do not understand is how many bonds are being called early and/or “sunk” early. I can independently verify Allan’s concern. I see individual’s buying bonds where they clearly do NOT understand what the risks are. For example, they buy a bond that has a 2/3 chance of LOSING MONEY and only a 1/3 chance of achieving the yield to maturity. Allan documents a single bond that illustrates this risk:

You should be especially wary of muni bonds trading at fat premiums above face value.

Here's the deal. Unlike U.S. Treasury securities and many corporate bonds, lots of investment-grade muni bonds can be -- and will be -- called in for early redemption by their issuers. That means that muni bonds' apparent interest yields are way above the actual yield that you'll get if you buy at today's price.

Let's look at a security that I own: a New Jersey transit trust fund bond bought at about face value when it was issued four years ago. This bond, which pays 5.25% annual interest and is due in June 2023, currently trades for 120.505% of face value, according to the most recent Bloomberg quote. On the surface, its yield looks pretty good in these ultra-low-rate days: 4.36%. You get that by dividing the 5.25 of interest by the bond's market value of 120.505.



However, you're not going to get 4.36% on the bond. Why? Because New Jersey is scheduled to redeem it, at 100% of face value, less than 11 years from now. Buy a $10,000 bond for $12,051 today, and in 2023 you'll get back $2,051 less than you paid. That offsets a good part of the interest you'll get over the bond's remaining life. By Bloomberg's math, your "yield to maturity" is only 3.05%. A heck of a lot less than 4.36%.

But wait -- it gets worse. New Jersey has the right to redeem the bond at face value in June 2018, less than six years from now. If rates remain anywhere near their current levels in 2018, this bond will be redeemed fast enough to break the sound barrier. That produces some sorry math: Pay the aforementioned $12,051 for your bond, get redeemed out for $10,000 in 2018, and your "yield to worst," as it's known, is 1.66%. Yechhhh!

. . .

But make no mistake: Even though people like me aren't selling, anyone with a bond calculator and a knowledge of financial history knows that investment-grade munis like mine are priced at bubble levels. And that bubbles last longer than you think they will but always pop in the end. And that when boring investments become exciting ones, it's time to keep a firm grip on your emotions -- and on your wallet.


To give you an idea of the magnitude of this problem, almost half of the muni bonds issued in 2012 are to refinance old issues according to some sources. Any municipality that can refinance will likely do so. And guess what, Wall Street is more than happy to accommodate them since they get more underwriting fees. Pretty much the same as a homeowner refinancing a home loan. Every time a municipality refinances, it means that some existing bonds will be called early.

You also see this on corporate bonds and CD’s to a lesser extent. So it is possible to overpay for them also. This can also be an issue with bond funds, once again to a lesser extent. Bond fund managers certainly understand call risk, but sometimes they are willing to take a chance on a particular offering.

BOTTOM LINE is that it is extremely important that investors understand the call and/or sink provisions before buying any bond or CD, but particularly muni bonds. Yoda sees cases every day where unsuspecting individual investors clearly do NOT understand this risk.

Thanks,

Yodaorange



[1] Allan Sloan Fortune article on muni bonds
http://finance.fortune.cnn.com/2012/12/05/municipal-bond-bub...
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