Pity the poor municipal bond fund managers. Every few years, they are called on to defend the sector in the face of worries about a debacle in the muni market.
This is another of those times. Among the reasons that bears are wary of the muni market: Detroit’s default last summer, Puerto Rico’s looming (as of mid-January) downgrade, Illinois’ mounting pension obligation and the Federal Reserve’s decision to begin tapering its $85 billion monthly bond-buying program. The S&P Municipal Bond Index was down 2.3% for the year that ended on Jan. 7 — ouch.
But Christopher Alwine, head of Vanguard’s municipal bond team, has seen this before. He has been managing municipal bond funds since 1991, and over that period he has witnessed some bleak times.
In 2008, the worldwide financial collapse seized up credit markets — and bond insurers, once ubiquitous, experienced credit problems all their own.
That led investors to question the creditworthiness of munis and the eventual departure of insurance from the market.
The worst fears passed — until 2011, when prominent banking analyst Meredith Whitney predicted a massive wave of municipal bond defaults. (They didn’t happen.)
By comparison, Alwine says, today’s worries are relatively modest. “When munis have a bad year, it’s not all that bad,” Alwine says of the recent dip in the sector’s performance.
RARE DEFAULTS
Although muni default rates are on the rise since the financial crisis, they are still extremely unusual. According to Moody’s Investors Service, the default rate for munis rated by the firm is 0.03% over the last five years.
And compared with corporate bonds, the recovery rates — that is, the amount of money that bondholders eventually wrangle out of the issuer after a default — looks good too: 65% for muni bonds versus 49% for corporate bonds.
In 2012, as hungry investors looked for yield advantage, munis were a natural place to get it with relatively little risk. But 2013 proved something else, amid the Detroit bankruptcy and fears about an impending ratings downgrade for Puerto Rico.
THE CASE FOR OWNING
Despite the headlines, Alwine says, the case for munis is strong. First of all, the income produced by munis is tax-free; that is especially important now that the net investment income of high-income individuals is subject to a 3.8% Medicare surtax.
And when problems do flare up in the muni market, they don’t tend to be contagious, Alwine insists. Part of this has to do with the sheer number of issuers — there are tens of thousands of them. In addition, the financial troubles in one jurisdiction tend to be unique. So, highly publicized troubles in a few locations aren’t necessarily symbolic of difficulties throughout the market.
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The views expressed here are that of myself or the cited individual or firm and do not constitute a recommendation, solicitation, or offer by myself, D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
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