When it comes to the municipal bond fund market, don't expect any buy signals from Jonathan P. Kahn. He characterizes the muni fund market as a fool's paradise and believes investors in muni bond funds will only be further disillusioned.
"It's a bad, deceptive product, filled with pitfalls," claims Kahn, a private investor who lives in New York City and invests for his own accounts. He is a longtime client of Bill Hayes, a principal of Charles Carol Financial Partners based in Washington, D.C., and Boston, and a former representative in the Fidelity Investments Private Asset Group, where the client minimum is $1 million.
"It's easier to buy individual bonds and get your money back at whatever maturity you choose, so why buy a fund for diversification as opposed to doing a little homework?" Kahn maintains. "Like many say that life insurance is sold not bought, the same applies to municipal bond funds. If you're looking for gains, stay in the stock market" rather than muni bond funds.
The $2.9 trillion muni market is going through an identity crisis. Its holy sacraments of reliability and safety have come under attack. Threats of default by states and municipalities have roiled a once-placid sector whose low-risk, low-return vehicles year in, year out were almost unalterable givens.
Muni prices were especially hit in the early fourth quarter when investors faced pessimism over defaults. That attitude was characterized by bank analyst Meredith Whitney, who made a well-publicized prediction in December 2010 that there would be 50 to 100 municipal defaults totaling hundreds of billions of dollars in 2011. It caused a steep sell-off. But even before that, many muni investors had begun retreating to other harbors.
From October 2010 through late February 2011, over $37 billion flowed out of muni funds, according to the Investment Company Institute.
The main culprits are lack of adequate disclosure and wounds to the safety record of muni bonds, discontinuation of a federal bond subsidy program, combined with the steady drumbeat of headlines about state and budget shortfalls, according to experts. Also unsettling have been revelations that states face up to $1 trillion in pension and benefits shortfalls.
A consulting firm co-founded by well-known economist Nouriel Roubini added fuel to the fire in March 2011 by predicting there would be close to $100 billion in defaults over the next five years. The fact that both Whitney and Roubini had correctly predicted troubles ahead of the 2008 financial crisis lent an aura of omniscience to their pronouncements.
But aside from these problems, real and perceived, the main fear looming over the bond market these days is more visceral: the fear that the Federal Reserve may soon raise interest rates, which would lower bond prices and investor returns. Fed Chairman Ben Bernanke went to Congress earlier this year and discussed the potential for raising interest rates.
In the wake of such events, how should you counsel clients? Are munis a category to be avoided at all costs, or is that an overreaction?