What's Up With Muni Bonds
Muni bonds are getting media coverage - finally. Over a year ago we were writing about the issues surrounding these babies, but it took a big drop in the price of some muni bond funds to get anyone's attention. Let's take a look at where things are now.
Whether you consider the stuff put out to the public or what's being published in professional trade publications, the main common themes are the bad financial condition of municipalities, the volatility of muni bonds right now, and the ultimate risk of default of muni bonds. We'll look at these themes in order.
Bad Financial Condition of Municipalities
The worst states are California, Illinois and New Jersey at this point. They're getting the bulk of the press, rightly so since they're financial basket cases. I live in New York, and we're probably not far behind. The governor just said the state was "functionally" bankrupt, whatever that means.
The important thing to remember here is that, when it comes to muni bonds, you've got bonds issued by different governmental entities. In addition to states, bonds are issued by cities, counties and towns. I'm not going to get into all the different types of bonds issued here, but be aware that just because New Jersey bonds might be shaky based on the state's finances being in the toilet doesn't mean that some town's bonds might not be OK if the town has been well managed and its debt levels and future liabilities are manageable. On the other hand, remember that if the local town depends on the state for ongoing revenue, that will potentially put the town in jeopardy simply because the state may not fork over the money in the future that they have in the past.
Volatility of Municipal Bonds
Remember that volatility just means that prices move up and down. So saying muni bonds are volatile really means that the price of muni bonds is moving up or down (mostly down now) more than they typically do.
If you own individual bonds, and are going to hold them to maturity, you're concern might be less with the price changes up and down than with the risk of default (see below). If you hold bond funds, you'll see the price bob up and down more than usual. And if you're thinking of selling the fund soon, or a portion of it, because you want to raise cash (e.g., to spend or to buy some stocks or some other asset), you could lose a lot of money if you cash the fund in when it's price is down.
Remember too that when prices are volatile, you can make money as well as lose it. So, for example, with prices of bond funds having dropped recently, some people might be buying these funds figuring they'll snap back and they'll scalp a profit doing that. That's because nothing just goes straight down in price (unless you're looking at a defaulting bond). Typically if things go down a lot, there's some snap-back in price. Of course, the price could snap back and head right back down again. So if you play the game of catching the snap-back to scalp a profit, you have to know when to sell to make sure you grab your profit and not just give it right back when the item heads down again.
Risk of Default
Analyst Meredith Whitney made big headlines predicting that hundreds of municipal bonds would default. Now you see people saying she exaggerated. Municipal bond managers (who only make money when people invest in muni bonds) use their old argument that municipalities won't default because if they do they'll never be able to borrow again. In addition, there are the voices that simply say that things will work out - in essence that they'll have to be worked out.
The there's always the argument that if you pick bonds that are "credit-worthy" it won't matter to you if crappy bonds default. Of course, either you have to know how to evaluate the creditworthiness of the municipality that issues the bonds, as well as understand the terms of the bond instrument itself, or you have to utilize the services of someone who does.
I'm not convinced that Whitney's correct, but I don't think you can signal the "all clear" on muni bonds. If I had a huge exposure to these things (and I don't), I would be concerned.
Whether you consider the stuff put out to the public or what's being published in professional trade publications, the main common themes are the bad financial condition of municipalities, the volatility of muni bonds right now, and the ultimate risk of default of muni bonds. We'll look at these themes in order.
Bad Financial Condition of Municipalities
The worst states are California, Illinois and New Jersey at this point. They're getting the bulk of the press, rightly so since they're financial basket cases. I live in New York, and we're probably not far behind. The governor just said the state was "functionally" bankrupt, whatever that means.
The important thing to remember here is that, when it comes to muni bonds, you've got bonds issued by different governmental entities. In addition to states, bonds are issued by cities, counties and towns. I'm not going to get into all the different types of bonds issued here, but be aware that just because New Jersey bonds might be shaky based on the state's finances being in the toilet doesn't mean that some town's bonds might not be OK if the town has been well managed and its debt levels and future liabilities are manageable. On the other hand, remember that if the local town depends on the state for ongoing revenue, that will potentially put the town in jeopardy simply because the state may not fork over the money in the future that they have in the past.
Volatility of Municipal Bonds
Remember that volatility just means that prices move up and down. So saying muni bonds are volatile really means that the price of muni bonds is moving up or down (mostly down now) more than they typically do.
If you own individual bonds, and are going to hold them to maturity, you're concern might be less with the price changes up and down than with the risk of default (see below). If you hold bond funds, you'll see the price bob up and down more than usual. And if you're thinking of selling the fund soon, or a portion of it, because you want to raise cash (e.g., to spend or to buy some stocks or some other asset), you could lose a lot of money if you cash the fund in when it's price is down.
Remember too that when prices are volatile, you can make money as well as lose it. So, for example, with prices of bond funds having dropped recently, some people might be buying these funds figuring they'll snap back and they'll scalp a profit doing that. That's because nothing just goes straight down in price (unless you're looking at a defaulting bond). Typically if things go down a lot, there's some snap-back in price. Of course, the price could snap back and head right back down again. So if you play the game of catching the snap-back to scalp a profit, you have to know when to sell to make sure you grab your profit and not just give it right back when the item heads down again.
Risk of Default
Analyst Meredith Whitney made big headlines predicting that hundreds of municipal bonds would default. Now you see people saying she exaggerated. Municipal bond managers (who only make money when people invest in muni bonds) use their old argument that municipalities won't default because if they do they'll never be able to borrow again. In addition, there are the voices that simply say that things will work out - in essence that they'll have to be worked out.
The there's always the argument that if you pick bonds that are "credit-worthy" it won't matter to you if crappy bonds default. Of course, either you have to know how to evaluate the creditworthiness of the municipality that issues the bonds, as well as understand the terms of the bond instrument itself, or you have to utilize the services of someone who does.
I'm not convinced that Whitney's correct, but I don't think you can signal the "all clear" on muni bonds. If I had a huge exposure to these things (and I don't), I would be concerned.
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