Volatility is a very important discussion to have with clients before they invest. In many cases clients will choose bonds over stocks because of a perceived lower level of volatility found there. Historically, that’s a fair assumption–rarely if ever in the past 20 years has a portfolio of municipal bonds represented a similar level of risk to stocks. People are also taught to buy bonds for the yield and to not pay close attention to daily fluctuations in price. Well, like a lot of other things, 2008 has changed the rules. Bond volatility combined with mark-to-market accounting rules has helped crush the daily trading prices of many bonds. It has also caused a phenomenon of highly rated bonds offering competitive yields. So, does this present an opportunity for investors? Here are a few things to know:
First, many industry experts and financial planners whom I’ve spoken with believe some of the best bond market opportunities are in the municipal markets. Municipal bonds generally pay a lower rate of interest than corporate bonds in exchange for better safety. Unlike corporate issues which rely on consumer spending and other variables, municipals generate income through more reliable tax revenues, tolls and other consistent sources of revenue. An added benefit is that many municipal bond issues are exempt from federal and/or state income taxes—although not all, so you’ll want to contact your financial and/or tax professional for confirmation.
The yield surge phenomenon is directly correlated to the drop in bond prices. Among the major factors which have caused these steep price drops are the heavy selling volume on behalf of hedge funds and other institutional investors who need to raise cash to meet liquidations requests. The bond market selloff was further exacerbated after investors lost faith in rating agencies which made determinations about the riskiness of each issue. Once it came to light that rating agencies were more focused on generating profits than giving honest assessments of bond risks, the liquidation requests continued to roll on. The sub-prime mortgage mess made the rating agencies look somewhat negligent and many investors have decided to sit on the sidelines during periods of uncertainty.
The unfortunate part of the municipal bond story is that the current recession and lack of consumer confidence only makes the actual problems for the municipalities worse. The deteriorating financial sector directly equates to lower tax revenues for New York City, where I live. The fewer people traveling to and from the city, the less revenue we collect as a result. All of these factors serve to legitimize the lower pricing of bonds, rather than encourage their rebound. Because we shouldn’t just trust rating agencies to decide for us what the real risks of a bond investment are, investors need to proactively look into the credit risk of a bond before buying it.
One should also look at whether or not a bond investment is leveraged. Leverage has been poison to the market over the past year or so. It may be prudent to avoid investments which utilize leverage to ‘juice up’ the returns.
What we do know is that very few (less than 1%) of municipal bonds have actually defaulted, at least here in New York City. Default risk is truly the largest concern a bond investor should have if they plan to buy a bond and hold it to maturity. So, we know that fear has pervaded the market and at this point is somewhat responsible for continuously lower re-pricing. Over the long-run, if and when we do bounce out of this recession, municipals may prove to be an excellent long-term investment.
Question, comments? Feel free to e-mail me.
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Corporate bonds are subject to interest rate risk. Investors should be aware that bond values may decline, if interest rates rise. Municipal bonds, corporate bonds, US Treasury Securities, Government Agency Bonds, and CDs will fluctuate in value and if sold prior to maturity may be worth more or less than their original cost.
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.