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Blue Haven Capital interviewed by SmartMoney.com
The original article by Aleksandra Todorova of SmartMoney.com can be viewed here.
Chasing Muni Yields Carries Risks by Aleksandra Todorova May 8, 2008
MUNICIPAL BONDS, let's face it,
could make anyone snooze. "They're complicated and boring," says Donald
Cummings, principal of Blue Haven Capital, a fee-based
wealth-management firm in Geneva, Ill. When he brings up the subject at
cocktail parties, he says, people walk away.
These days, Cummings may find it easier to grab listeners'
attention. Over the past two months, municipal bond yields have
consistently exceeded Treasury yields, even before factoring in the tax
advantage. As of May 7, 30-year Treasurys yielded 4.61%, while
AAA-rated (the highest credit quality) municipal bonds of the same
maturity hit an average 4.88%. Since interest earned on munis is tax
free, that's the equivalent of a taxable investment yielding 7.3% for
someone in the 33% tax bracket, or 6.5% for someone taxed at 25%.
Shorter-maturity Treasurys were also close, or lower than AAA-rated
munis on a pretax basis, while munis rated AA or lower exceeded
Treasury yields on all fronts. "I've been in institutional trading and
sales of municipal bonds since the late 1980s and I've never seen such
a run," says Cummings. "Never all through the curve and never for so
long."
Normally, municipal bonds yield less than Treasurys, with the tax-free
interest making up the difference for investors in the highest tax
brackets. But the credit crunch and concerns with bond insurers' downgrades
caused many institutional investors to sell off munis and other
securities not guaranteed by the government. "There was a flight to
quality in the past 12 to 15 months where investors sold anything with
risk and bought Treasurys," explains Scott Berry, senior fund analyst
with research firm Morningstar. The selloff suppressed muni prices and,
consequently, pushed yields up. Increased demand had the opposite
effect on Treasurys.
As a result, investors as low as the 25% tax bracket may be compelled
to shift a part of their fixed-income portfolios to municipal bonds.
And given the paltry returns of money-market funds and savings accounts
these days, munis may even sound like a good place to park your extra
cash.
For most investors, however, the risks outweigh the returns.
"Right now the yields look fantastic and juicy, but they're juicy for a
reason," says Michael Boone, a fee-only certified financial planner in
Bellevue, Wash. Housing-bust spilloverThanks to low default rates, municipal bonds have historically been
considered extremely safe. But the weakening economy and plummeting
housing prices have put the health of some municipalities at risk,
raising questions about their ability to repay debts. "The overall
feeling is that as the economy weakens, a lot of these municipalities
may not be in good shape, so there's a fear that their credit quality
may decrease," says Boone.
If a municipality relies largely on collecting real estate taxes, for
example, falling property values would cut into revenues - a problem
that many municipalities have not had to deal with in recent history.
Just this week, the Northern California city of Vallejo declared
Chapter 9 bankruptcy, allowing it to continue providing services while
freezing its debts. When a municipality declares bankruptcy, the bond
insurer would typically take over payments of principal and interest,
Boone explains. But should the number of such bankruptcies increase,
investors now question the ability of insurers to take over the
financial burden.
Hence, the importance of location, Boone warns. "A real estate-led
decline, unlike other struggles in the economy, is very much localized.
When we build a portfolio for clients, we consider geographic
diversification just as important as maturity diversification and
credit diversification."
For a combination of high yields and safety, Cummings recommends
pre-refunded or escrowed-to-maturity bonds. These are bonds that
municipalities have refinanced into Treasurys at some point in the past
to take advantage of lower interest rates. Since they continue making
the original coupon payment, investors get higher yields for a security
backed by the government.
Liquidity concernsMunicipal bonds
trade infrequently, which makes pricing difficult, says Jeff Tjornehoj,
research manager at financial research firm Lipper. "Your broker may
buy it from you and execute the trade as quickly as possible, but if
the last bond sold six months ago, how do you know [you're getting] the
right price?" A lack of buyers could mean that you take a hit on your
original investment.
That makes buying individual bonds with your emergency cash a bad idea,
says Gary Schatsky, a fee-only certified financial planner in New York.
"An emergency fund is something you could liquidate right away without
having your arm cut off," he says. Inflation riskWith yields exceeding 4% on AAA-rated bonds, those 20- or 30-year munis
may be hard to resist. But locking your money in for a long period of
time in today's low-interest-rate environment exposes you to inflation
risk. "A lot of people say if you hold a bond to maturity you have no
risk, but that's a lie," Schatsky says. "If you're getting 5% for 20
years and everyone else is getting 6% for 20 years, you're kidding
yourself if you think you're not losing money." Steve McLaughlin, director of business analytics at Municipal
Market Advisors, recommends three- to five-year bonds. Faced with lack
of demand for so-called adjustable-rate securities, or long-term bonds
with floating rates adjusting every seven, 28 or 35 days,
municipalities are now forced to restructure them into bonds that
mature in three to five years. That causes an oversupply that
suppresses prices and, therefore, increases yields, McLaughlin
explains. Hidden costsIndividual bonds are purchased through brokers, whose commissions can
be exceptionally high, Schatsky says. That's why he warns investors
with less than $100,000 to spend to stay away from individual bonds.
"For more modest purchases, I am inclined to look at no-load, low-cost,
diversified muni bond funds," he notes. Morningstar's Berry recommends looking into the tax-exempt funds
offered by Vanguard, Fidelity or T. Rowe Price. "You get really good
management and low cost," he notes. But don't expect impressive yields:
The average municipal bond fund has actually lost 1.31% year-to-date,
according to Lipper.
Cost-conscious investors may also look into muni bond ETFs, such as the iShares S&P National Municipal Bond (MUB: 100.95, +0.12, +0.11%) or State Street's SPDR Lehman Municipal Bond (TFI: 22.02, +0.10, +0.45%)
funds. Since they track an index, ETF yields are also on the lower
side, McLaughlin says. For many investors, however, the pros - lower
costs, liquidity and diversification - may outweigh the cons.
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Blue Haven Capital is a registered investment advisor focusing on socially responsible investment management for individuals, private foundations, and public charities. If you know an individual or group who might be interested in our services, please forward this email to them!
Best Regards,
Donald Cummings Principal
Bill Moucka Principal
Blue Haven Capital LLC
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