Municipal Bond Risk

Municipal bonds are found in the portfolios of many higher income investors.  They have experienced great returns over the last 30 years.  Part of that has come from interest payments and part has come from bonds price appreciation.  Remember, falling interest rates (and we have seen interest rates fall since 1980) leads to higher bond prices.

The problem for bond investors is that rising interest rates have the opposite effect: bonds go down in price when rates go up.  And today’s low rates are largely being engineered by Federal Reserve policy of low, low rates to spur a slow-growth economy with high unemployment.  When the Fed stops easing, we can expect rates to rise, and perhaps rise rapidly.

Here’s Morgan Stanley’s take:

Investors in the $3.7 trillion municipal market will probably face negative returns in 2014 following declines this year, the first back-to-back annual losses since at least the 1980s, according to Morgan Stanley.

The company’s base-case scenario for city and state debt in 2014 calls for a loss of 1.7 percent to 4.1 percent, Michael Zezas, the bank’s chief muni strategist, said in a report released today. A year ago, he correctly predicted that munis would lose money in 2013 as yields rose from the lowest since the 1960s.

In addition, we have seen a rash of municipal bankruptcies which causes investors to be concerned about getting their money bank if a city defaults on its obligations as Detroit is set to do.

For investors who have accumulated large municipal bond positions either as individual bonds or as bond mutual funds, caution is the watchword.

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