The first quarter’s $3.5 billion oversubscribed sale of Puerto Rico high-yield bonds may have signaled a dramatic investor reversal in sentiment from the final quarter slump of 2013. To be seen is whether enthusiasm is sustained across higher-rated, lower-yield bonds. Regardless, advisors will be fielding more questions as risk, regulation and choice evolve for the once-simple investment.
By the third quarter of 2013, the U.S. muni bond market had fallen to a four-year low. Anxious investors yanked $62.6 billion out of the market—$780 million from exchange-traded funds—even while $13 billion flooded into other U.S. exchange-traded bond products. But April has a way of making the heart leap toward tax-exempt securities. And muni bonds still symbolize a safe place for pre-retirement and retiree nest eggs. Which explains why financial advisors still recommend them.
“Irrespective of credit quality, there is tremendous demand for tax-exempt bonds,” says Dan Heckman, senior portfolio manager and senior fixed-income strategist for the wealth management division of U.S. Bank in Kansas City, Mo. But examples of municipal and state debt and related court decisions make it hard to advise clients who ask, “Are municipal bonds still a good idea for me?”
That answer is no if clients are looking for meaty returns. Yields have not rebounded despite repayment risk from underfunded pensions and post-employment liabilities in places such as Puerto Rico, California, Michigan and Illinois. “Even with stress issues, yields are not as high this week,” Heckman noted in late March. It’s a safe assumption then that investors are more drawn by a desire to preserve capital. But a shortage of bonds could drive these yields up, since a crisis-driven distaste for borrowing has led to “a dwindling supply of new issues,” he says.
Limited supplies of general obligation bonds could also mean that advisors may have to leave their comfort zone and delve into parts of the less-familiar muni spectrum: dedicated tax, dedicated trusts, schools, revenue, hospital, toll road, sewer, water, parking and electrical authorities, industrial development, redevelopment, tobacco bonds and life care facilities, to name a few.
Investing in munis for retirement adds its own layer of complexity. “In retirement, my clients’ incomes can go low enough that the tax-free benefit may not help them,” says Linda Leitz, a certified financial planner and founder of It’s Not Just Money, a Colorado Springs, Colo.-based firm. Bond “rates have been so low, and the differential between what a corporate bond might pay—or sometimes a certificate of deposit (CD)—may not warrant the bond risk,” says Leitz, whose firm offers tax and retirement investment advice. Her clients today must make a lot more money for the tax benefit to matter. “Just eight or 10 years ago, that wasn’t the case.”
There is also growing skepticism about whether riskier issuers like Puerto Rico (whose bonds yielded 8.7% when issued in March), Detroit, Chicago or California will actually manage their money well after their crises pass. Financial Times’ columnist Henny Sender quoted a private banker on March 17 who wrote to clients that the income of Puerto Rico “may never catch up to rising debt service,” even if the island cuts its spending. Sender also noted that California plans to spend its surplus tax revenue instead of applying it all to debts.
Leitz isn’t boosted by Detroit’s court victory either. “Detroit’s a problem,” she says. Under the bankruptcy court’s decision, general retirees stand to lose just under 30% of their pensions, and bondholders could get an 80% haircut on what they’re owed.
“Investment advisors shouldn’t just jump on the bandwagon,” by running back into an issue on the latest news, she says. “They should ask, what does this particular city’s problems mean for my client in the long term.” And, of Detroit in particular, Leitz cautions, “Every push has a resulting counter-push. A lot of people who hold those Detroit bonds probably have worked for government or a related entity. While they may not lose their pensions, they’ll have less income in retirement. And that, while it may have eased tensions over the bonds, may have a ripple effect on the economy.”
All of this “can lead investors and advisors to say stay away from the muni market,” says Stephen Winterstein, chief strategist for municipal fixed income at Wilmington Trust Investment Advisors, in Wilmington, Del. Winterstein’s firm sold its Puerto Rico bonds two years ago and has no plans to go back in. The lack of progress there, he says, “caused us consternation. Yet the overall market [for government bonds] tends to be high quality.”
But how many advisors can follow the asset class at this level? Regardless of investment vehicle, for Leitz it comes down to who is going to monitor it. For example, she concedes the argument for holding individual bonds “so clients can lock in returns.” The risk, of course, is more concentrated than it would be in an index of bonds of mixed credit value. But bond funds also require close monitoring, she says. “If one of the holdings goes under, it can probably impact the fund.”
The need for such granular oversight may push advisors to consider deferring muni portfolios to full-time managers such as Wilmington Trust and U.S. Bank, which are speaking up about the complexities of muni markets, no doubt with an eye toward directing advisors to their services.
Alliance Bernstein, for example, has the power to buy munis in $7 million lots, which lowers per bond cost, according to Michael Brooks, a senior portfolio manager in the N.Y.-based municipal bond group. Bernstein’s typical client brings at least $3 million to the firm, but it also has two advisor-sold muni funds for under 60 basis points.
Advisors who do provide the monitoring will find the Municipal Securities Rulemaking Board (MSRB) EMMA Web site a useful tool for following municipal finances, trades of muni bonds by their CUSIP numbers and other information.
Sources caution that you should screen bond brokers carefully. Some have been fined for charging muni bond investors “twice as much in trading commissions as they would for corporate bonds,” according to a Wall Street Journal report. Changes proposed by the SEC and MSRB to protect investors are being opposed by lobbyists for Charles Schwab & Co. and Wells Fargo Advisors LLC, which was fined by Finra for charging unfair prices on muni bond transactions.