Armageddon for Muni Bonds?
Board: Macro Economics
The recent Detroit bankruptcy has many investors questioning the future for municipal bonds. While Detroit was big news on Main Street, it came as no surprise to professional muni bond investors. Detroit’s problems have been widely known for several years. What was new about Detroit was their proposal to force haircuts on the general obligation aka GO bonds. The bond prospectus states: 
The Bonds will be full faith and credit unlimited tax general obligations of the City duly authorized by the City’s voters and secured by a pledge of the full faith and credit of the City. The City is authorized and required by law to levy and collect ad valorem taxes without limitation as to rate or amount upon all taxable property. . .
The fact that the Detroit Emergency manager proposed not paying the GO bonds in full is troubling. Back in April the SEC had a round table with many constituents from the muni bond market. Regulator, dealers, brokers, customers and fund managers were present. SEC commissioner Dan Gallagher got a lot of press for commenting: we've got Armageddon on our hands. 
Are muni bond investors heading for Armageddon? Or has the Detroit bankruptcy created a buying opportunity for certain bonds? I decided to separate out the different factors influencing the buy/sell/hold decision and hopefully shed some light on them. Here are the major factors I see:
1. Are GO unlimited tax bond payoffs still sacred?
2. Other bond types: Revenue, private party, pension obligation, general fund
3. Will pension holders take precedence over bond holders?
4. Bid/ask spreads for individual bond buyers
5. Illiquidity for individual bond buyers
6. Will muni interest become taxable?
7. Ratio of muni interest rates to US treasury rates
8. Potentially rising interest rates
9. Call provisions
10. Bonds from different municipalities
These issues cover too much ground for one post, so I decided to break it into multiple posts. Out of the ten different factors, which ones should investors be the most concerned about today? I have chosen to discuss the top two IMO.
Main Street investors do NOT understand bond math.
I am willing to bet that most METARites understand bond math. In its most simplistic form, bond prices and rates are opposite ends of a seesaw (teeter-totter in some parts of the country). When rates go up, prices go down. The further out the maturity date, the more pronounced the move. I.e., a 1% change in interest rates on a 10 year bond causes prices to move ~10X more than on a 1 year bond.
I have yet to find a Main Street casual investor that understands these financial physics facts. It is NOT because they are lazy, low IQ or low net worth. Many assertive, smart, high net worth individuals do not understand them. It is clear to me that bond mathematics is NOT “intuitively obvious” as you have heard in college science classes. Most main street investors are SHOCKED to see how far their bond funds drop when interest rates increase. For some reason, they do not show the same shock when interest rates fall causing their fund values to rise. Maybe rising prices reinforce their bias of being “smart investors” for having chosen those bonds.
This failure to understand bond math is a major risk factor in a bond Armageddon scenario. If you are NOT prepared for decreasing prices when interest rates rise, it can be traumatic. And this is on an asset class where most investors think they “cannot lose money.” After all bonds are safe and “guaranteed” in investors’ minds.
This brings us to:
Potentially rising interest rates
The May-June rise in interest rates had a strong effect on many of the high yielding asset classes. Muni bonds were hard hit, losing a median of ~10.0% from 5/17/13 through 7/26/13 on the funds I track. It was worse, but the asset prices have rebounded somewhat since the lows. Year to date, they are down 9.9% which is a relative disaster. With the S&P 500 up ~18.75% YTD, muni investors are having a terrible, no good kind of year. Thirty one of the muni funds I track are down more than 15% YTD.
The 10% to 15% YTD loss is all with Chairman Bernanke hinting that the Fed might start tapering back their bond purchases. I am sure many investors that hold these funds were quite shocked when they received their May and June statements. Imagine thinking that you own an asset that cannot go down in value until you discover it is down 15%. Not a pretty sight.
The most recent accurate forecaster of long term US treasury rates is the team at Hoisington Investment Management. They have been consistently forecasting lower long term rates for many years. Their last report continues to forecast flat to lower long term rates: the secular low in bond yields has yet to be recorded.  As long as Hoisington’s crystal ball is clear, all will be well with muni bonds.
The question is how long will the US have low long term rates? Increasing rates pose the same risk to long term US treasuries as well as long term muni issues. This is mostly an issue with the longer term holdings. If you own a bond or fund that matures in one year, then you will not risk much if long term rates increase. As each bond matures, it will be replaced with another one with a higher yield. That does NOT work so well if your bond matures in 10 or 20 or 30 years. If you own individual bonds and hold them to maturity, you know exactly what you will receive. If you own a bond fund that holds long term bonds, you have NO guarantee what the value will be say 10 or 20 years in the future.
Yoda’s opinion would be that it is OK to own bond funds with short maturities, say 1 to 5 years. I would NOT want to own bond funds with 10 to 30 year maturities, due to the uncertain asset value that far into the future. If you MUST own maturities that far out, I would tend to hold individual bonds. Ignoring default risks for the moment, you know exactly what you will receive. Personally we do NOT hold any 10 year+ bonds or bond funds in any of the widows and orphans portfolios. We might be 100% wrong in expecting interest rates to increase sometime between now and the next 10 years. Maybe 10 years from now, Hoisington puts out another report forecasting yet lower interest rates.
BOTTOM LINE is that IF an investor suffers an Armageddon in muni bonds, the two most likely causes will be due to flunking bond math and increasing interest rates. If the investor understands these risks, it will NOT be Armageddon. It is only Armageddon in the sense that the investor thought he could not lose money, only to find out that his asset value is off by 50% or more.
 Example of Detroit GO Bond Prospectus
 SEC's Gallagher: No apologies for muni 'Armageddon' comment
 Hoisington Investment Management Q2- 2013 Quarterly Review and Outlook