A number of financial Web sites are posting excerpts from Morgan Stanley Smith Barney’s Global Investment Committee Report for February. The municipal bond portion of the piece was featured recently in the “Income Investment” section of Barron’s.
Although we are certain there are some very talented people who produce this report, we are absolutely baffled by the commentary and advice offered, particularly as a strategy for individual investors.
Sell your bonds?
The report suggests that investors start selling their bonds, arguing: “The impressive rally in municipal bonds that started in mid October has run its course, in our view.” It then lists a number of perceived headwinds that might “reduce the attractiveness” of muni bonds and reasons to sell.
“While we hold a long-term constructive view of the municipal market, we believe it is time to consider some selective selling,” the report says. “Accordingly, we advocate lightening up on 25- to 30-year debt with sub 5% coupons as well as low-BBB-rated and sub-investment grade paper… For buyers, we prefer state-level general obligation bonds, state-level appropriated paper, local general-obligation bonds and essential-service revenue bonds with mid-tier A ratings and higher, as well as AA-rated hospital debt within a maturity band of six to 14 years.”
To borrow a phrase from the texting generation, “OMG”!
First, the report’s emphasis on the possible end to price appreciation in the municipal bond market struck us as odd – considering this is not the reason muni investors buy bonds in the first place. And the report’s prescription for the alleged challenges ahead simply isn’t logical.
Practicality be damned
There is no conceivable way, in a market that has never been considered very liquid, that this strategy can be employed without a devastating impact on an individual investor’s portfolio.
As the title of the Barron’s column implies, municipal bonds are income investments. They are purchased for the income, not for capital gains.
Price appreciation is not a significant factor for sophisticated muni buyers because they don’t sell their bonds; they know unequivocally they cannot replace the income due to the spread between the “bid” and “offered” side of the market.
Reinvestable dollars are also reduced after capital gains taxes are considered.
Individual investors are not operating mutual funds. The thought of selling long-term BBB-rated bonds, yielding approximately 5.00% to 5.50%, and replacing them with short-term A and AA bonds, is laughable.
The average yield on AA six- to 14-year bonds is approximately 2.49%. The average yield on A-rated bonds in those years is approximately 2.60%.
Why would any bond investor choose to sacrifice more than half his tax-free income? Why would any broker tell a muni investor to dump the bonds he just sold him? Wouldn’t the investor wonder why he wasn’t advised to buy the shorter securities in the first place, when the yield on those bonds was significantly higher? If the investor sells his bonds and doesn’t reinvest the proceeds, how will he replace the income? Further, these exchanges would also likely require a reduction of principal.
If this isn’t enough of a deterrent, the suggestion that bond sales and purchases should be dictated by ratings also defies credulity.
Two major brokerage firms disappeared and countless others needed a government bailout because they relied on the ill-conceived ratings of fatally flawed mortgage securities, rather than basing their own investment decisions on the underlying credit of the securities they held.
We are aware that brokerage firms are compelled to hire financial analysts, and these experts are expected to opine on the future of the markets, but this Alice in Wonderland “buy this, sell that” advice is mystifying.
Fortunately, successful municipal bond investors have discovered the futility of trying to predict the future. They show no inclination to sacrifice their tax-free income based on the prognostications of the latest crystal ball gazers.
Even more meaningful, they are aware that it was the same seers, who never saw the current rally coming, who are now predicting its demise.