Here's what I said on November 25, 2010: Dumb Money Flows Out of Munis, Time to Buy In?
Here's what the WSJ said on March 3:
When many individual investors saw these declines, they began pulling money out of mutual funds, fund manager say. That forced funds to sell high-quality assets to meet redemptions. In the week ended Nov.17, investors had withdrawn an unprecedented $3 billion from muni-bond mutual funds.
Chart of total return on $100,00 invested in iShares S&P National Municipal Bond Fund ETF (MUB) (green) vs IEF 7-10 year Treasury ETF (blue) since the November sell-off (click to enlarge):
From Vanguard's advisor website:
"This was the most frenzied period I have ever experienced," says Mr.Miller, an 18-year investment veteran, who estimated his daily trades that week were four times their usual level....
But since late January, the market appears to be stabilizing. Yields on a benchmark 30-year general obligation bond have fallen 7%—only part of the way toward erasing the 22% rise between Veterans Day and Jan. 14.....
But since late January, the market appears to be stabilizing. Yields on a benchmark 30-year general obligation bond have fallen 7%—only part of the way toward erasing the 22% rise between Veterans Day and Jan. 14.
I think where we see some problems, though, at times is people react to some of the short-term volatility. So rates may rise. You may see your return below or even possibly negative for a short period of time, but it's over the course of the next number of periods—whether it be months, years, or whatever—where you're getting that higher income that makes up for that initial decline. But if you as an investor decided, hey, I don't want this — ... — decline and I got out, you don't get to benefit from that higher yield that will make up for that in a NAV decline or price decline.
But clearly, the loss aversion (greater pain of loss than pleasure of gain) observed by behavioral economists has kicked in among municipal bond investors. Municipal bonds are an asset class where most of the buyers are very conservative investors who are very quick to sell when they see losses on their bonds or bond funds. So where professionals may see an opportunity to pick up attractive yields, the retail investor sees a sell signal. From the WSJ:
Retail investors are missing out on attractive municipal bond yields as they focus on the unlikely event of major defaults, according to global asset manager BlackRock Inc.
"The oddity of the situation is that investors should be buying when the net asset value is lower and yields higher. But there are still outflows from muni mutual funds, though the outflow has slowed," said Peter Hayes, who heads Blackrock's municipal bond group.
As can be seen in the chart above, those that sold in the panic already may be regretting it. The Municipal Bond ETF (MUB) has actually outperformed the Treasury Bond ETF (IEF) since the November selloff when looking at total return. And since the interest income on the muni ETF is tax exempt, the after tax advantage or the MUB is even greater.
A Note on Muni Bond ETFs
Much has been written, notably by commentator Matthew Hougan at the well respected Index Universe, about the problems of pricing in municipal bond ETFs and bond ETFs in general. They assert that the bond ETFs traded at prices significantly different than the indicated price for the underlying index. For instance, during the large bond selloff in October it seemed that the price for MUB, the municipal bond ETF were significantly below those of the underlying bonds as indicated by the index. Therefore these analysts advised against using many bond ETFs including MUB, the municipal bond ETF.
This argument shows a fundamental misunderstanding of how bond markets and bond ETFs work in the real world. My analysis of the situation is quite the opposite and has been reinforced in conversations with staff at the ETF providers.
The problem with Hougan’s (and others') analysis is that the bond prices used for the index actually don’t reflect the true market value of the bonds in the index at any given time. The bond market is not continuous and bonds don’t trade on a single exchange with data for last trade publicly disseminated. The same bond can trade at different prices at different dealers at the same time. This is particularly true in municipal bonds
It is in times of crisis that the liguidity in municipal bonds is particularly thin and the prices for the same bonds and bonds with similar maturity and credit quality can diverge the most among various dealers.These are the times when the reported data for the indices are least reliable. But unlike many bond dealers, the market makers for the ETF continue to provide prices and liquidity.
Rather than the ETF not reflecting the true market values in the municipal market, the exact opposite is the case. The data used to compute the theoretical value for the index are not reflective of market conditions. But the ETF price where real money is put on the line actually do reflect market conditions.
Here's what the muni market looked like in the midst of the November selloff:
From the WSJ article:
"This was the most frenzied period I have ever experienced," says Mr. Miller, an 18-year investment veteran, who estimated his daily trades that week were four times their usual level.
Wall Street dealers, which act as intermediaries between the mutual funds, were requiring higher yields in order to buy the high-quality bonds, traders say.
"The dealers were bidding you cheap," says Thomas Doe, CEO of Municipal Market Advisers. "They know you need capital."
What are the implications of this with regard to ETFs?
Quite the opposite of Mr. Hougan’s analysis. The market makers in the bond ETF have to make a market that reflects where bonds are actually trading, not the price for the index on a screen. That price on the screen is based on prices for bonds that might have last traded several days prior.
On the other hand, the ETF market must reflect where bonds are trading. Market makers making prices for the ETF look where bonds are actually trading and calculate their best estimate of where the index as a whole is properly valued.
This market reality means quite the opposite of Hougan’s analysis of the ETF. In fact, the continuously traded ETF reflects where the market is actually valued.
In contrast to the ETF pricing it, is the muni mutual bond funds where there is lack of transparency. One has no idea of how the mutual fund is calculating the bond prices they hold in the fund when calculating their net asset value each day. Valuing the bonds in the fund portfolio is particularly difficult when faced with markets during crisis periods.
In fact, there have been reports of the dilemma many muni bond funds faced during the November crisis. The funds were forced to sell off positions as fund investors liquidated in the midst of the crisis. The funds found it difficult to sell the bonds at prices near where they had valued the bonds when reporting fund net asset value.
I am sure the price at which they sold the bonds was below the “mark to market” price used in calculating NAV. In some cases the differential meant the better term would have been “mark to myth”. The SEC is investigating this issue for some high yield municipal bond funds.
The holder of individual municipal bonds is in an even more difficult position than the bond market. In a normal market they face very wide bid ask spreads and when they buy or sell bonds it is well above/below where institutional investors trade.
I am not a believer in the apocalyptic forecast of muni bond defaults of analysts such as Meredith Whitney. For most states, debt tends to be the equivalent of state GDP, which is generally around 6% far, far below that of Greece. As Vanguard has written in a research paper, California is not Greece. The always insightful Felix Salmon gives a good balanced view of the issue and of Nouriel Roubini's gloom and doom analysis here.
So investors should still find a place for munis in their taxable holdings, particularly people like most of my clients: high tax rate individuals in a high tax state. In my view, those big selloffs (and they likely will continue to come) will be a buying opportunity.
What is the bottom line for individual municipal bond investors, particularly in a muni bond market that will doubtless be volatile in the future ?
- Don’t buy into munis at all if you can’t stand the volatility. And don’t invest money you may need for cash flow.
- The shorter the maturity the less volatility.
- Despite the tax advantage of holding bonds of the states in which one resides (like us folk in California) there is a good case to diversify with the majority of one’s holdings in national bond vehicles such as MUB or mutual funds rather than single state funds.
- Always calculate the after tax yield to look at the break-even rate vs.the taxable bond. Municipal bond yields have recently been at historic highs relative to Treasury bonds. Munis have even been trading at yields equal to those of Treasuries. Historically, muni bonds have traded with a yield around .85x that of Treasuries.
The formula for that calculation is municipal bond yield/(1- tax rate). For example, at a 35% tax rate a 3.5% yield municipal bond would have a taxable equivalent yield of 5.38%. In that example it would take quite a price drop to push the muni bond below the taxable bond in terms of total return (capital loss+ interest) .
Don’t buy individual bonds. The bid ask is too wide meaning you are trading at a discount/premium to the institutional market. You also have no guarantee of liquidity.
- This is one of the few cases where it might make sense to own an actively managed fund where there is credit analysis, as opposed to owning the ETF. A combination of ETF plus mutual fund probably makes sense. But be very careful about management fees: a 1% management fee on a fund yielding 3.5% is a huge cost. As is usually the case, Vanguard offers some very low cost municipal bond funds with fees as low as .12% for larger investors, .20% for other investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. My clients hold positions in IEF, MUB and several Vanguard municipal bond funds.