Stocks were succumbing to some selling pressure, while bonds were back on the rally parade at midday. Still, I want to return to the debate over whether last week marked a peak for fixed-income prices and thus, the nadir in yields.
How Safe is Your Haven, Part 3
Monday , I mused about developments in high-yield bonds, which are struggling to rebound from some devastating losses. A recovery in high-yield bonds could be a sign that investors' steep aversion to risk is abating. A revival of speculation, regardless of its merits, could bring some chill to the currently hot market for safe-haven fixed-income investments such as Treasuries and municipal bonds. Munis have been stellar performers, and not just this year. Long-term muni funds are up 5.84% thus far in 2002 after producing total returns of 4.84% for the past year, 6.13% for the past three years and 4.83% for the past five years, according to Morningstar. Even before adjusting for taxes, those returns compare favorably to long-term Treasuries and have outperformed nearly every category of equity funds. Short- and intermediate-term muni funds have produced similar results. Muni bonds often make great sense for individuals looking to shelter assets from taxes (speak to your accountant), and their appeal has only increased in recent years as equities have faltered. Through June, municipal bond funds enjoyed net inflows of $7.7 billion this year after raking in $4.8 billion in 2001, according to the Investment Company Institute. But even some staunch proponents of munis wonder if investors really know what they're getting themselves into. "In 1999, everyone was rushing lemming-like into equities and now the herd is dashing toward bonds," Alexandra Lebenthal, CEO and president of Lebenthal & Co., said in an interview last week. Some are "not necessarily doing it with the understanding that, at some point, yields will go up, prices will go down and people will lose money on paper," as was the case in 1994 and to a lesser extent, 1999. Lebenthal, whose firm (and father) helped revolutionize how individuals invest in munis, believes they remain a key component to most portfolios. That's provided muni fund investors reinvest dividends and "ladder" their holdings, meaning they invest in bonds of varying maturities. "I would hope investors would look at issues such as diversification, asset allocation, risk management and different managers' performance," she said. "But they're not. They're buying bonds because stocks aren't doing well." (At least, not until very recently.)
Meanwhile, issuance by municipalities was at a record pace through the first six months of 2002 and, not coincidentally, offerings of closed-end muni funds have been coming at a rapid pace. Neuberger & Berman and John Nuveen & Co. are both planning offerings of new closed-end muni funds for next month while existing issues such as the Nuveen Premium Income Muni fund ( NPI) are trading just below 52-week highs. To skeptics, this is evidence of people jumping on the muni bandwagon and of Wall Street crassly trying to pump as much related product as possible down the throats of retail investors. "There's no IPO market so closed-end funds are the only thing they're getting a syndicate payout" on, said one manager of fund of closed-end funds. "Beware of retail brokers calling up saying 'we have a new muni fund coming out.' The investors latest to the game are the ones that are going to get killed." The source, who requested anonymity, suggested that the timing of these offerings is particularly troubling, given what he (and others) see as growing instability in the finances of many municipalities. "As soon as you get a breath of rates going up, munis are going to get hammered," the fund manager said. The National Council of State Legislatures estimated budget deficits at the state level will total $58 billion this year, Bloomberg reported. California alone accounts for nearly half that total, with a projected budget gap of over $23 billion. California Gov. Gray Davis has proposed a series of state tax increases to help close the gap, but politicians in other states are wary about raising taxes in an election year. Instead, they have resorted to measures such as selling bonds backed by funds from the $285 billion settlement with tobacco companies. About $12 billion of so-called tobacco bonds have, to date, been sold by New Jersey, Wisconsin and Rhode Island. "State deficits seem to be growing and many states are looking to one-time fixes or plugs as a way of overcoming current-year budget deficits vs. raising taxes or cutting expenses," said John Goetz, manager of, among other muni funds, the ( TTFAX) Touchstone Tax-Free Intermediate Term fund, which is up 6.21% year-to-date. "If we don't see an economic rebound and continue to see weakness in state revenue receipts, I think you'll start to see some adjustment in bonds from specific states where deficits are continuing." Still, munis are priced relatively attractive vs. Treasuries, Goetz said, recommending investors look for higher-quality issues and insured bonds with short- and intermediate-term durations, which will presumably be less sensitive to an upward movement in rates. "You give up some yield, but it's worth it," he said. Clifford Gladson, who manages about $8 billion in municipal bonds at USAA Investment Management Co. in San Antonio, agreed investors must be aware of the potential risks of higher rates and state deficits. But he, too, argued munis are relatively cheap vs. Treasuries and observed that a 10% revenue shortfall at the state level is a "budget crisis," which gets attention from the press, voters and the opposition party. He contrasted this heightened transparency to the sometime opaque (and illegal) accounting at private firms, and suggested it means munis have higher credit quality than similarly rated corporate bonds. "Anyone in the 28% tax bracket and above can find a place in the yield curve where munis make sense on an after-tax basis," Gladson said. "It's a compelling argument if you're taking money out of the stock market. People who preserved some wealth are saying 'I want something more stable.'" More stable, yes, but not without risks, something which may not be apparent to many newbie bond investors.