The Real Fear For The Muni Market Isn’t The Default Rate

hand over mouth upset worry

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The potential for mounting debt and falling tax receipts to lead to huge defaults by state, regional, and local governments has precipitated many conference calls and webinars focusing on “setting the record straight” or “busting the myths” for municipal bonds.In each of these conversations I’ve heard a similar message: The default rate for municipal bonds is incredibly low, and while it may spike relative to recent history, there is still a shockingly low probability of real pain for muni investors from defaults.

There is actually a much larger and less-discussed issue facing the municipal bond market.

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To set the stage, let’s rewind and review a couple of key points about how and why municipal bonds have been a great investment in the past:

  • favoured tax status. Because these bonds are issued by government entities, generally they offer investors tax-free interest income. For high-net-worth individuals this can be a huge benefit.
  • Interest-rate sensitivity. The price and yield of a bond move inversely, meaning that as interest rates fall, bond prices rise and vice versa.
  • Falling-rate environment. Interest rates have generally been dropping since the last major peak in the early 1980s.

Because of the three factors above, the real fear for the municipal bond market will arise when the primary pool of muni-bond holders (high-net-worth individuals) begin to see the previously rising values of their bond accounts begin to drop quickly.

Due to falling interest rates, most of these investors have only experienced ever-growing bond prices—and thereby reasonable total rates of return after tax—their entire investing lives. Very few have ever lived through a meaningful rising interest-rate environment. When these generally conservative investors begin to see sharp drops of 10 per cent or more in their “safe” accounts over short periods of time, history tells us they are likely to panic, and sell fast.

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With the downturn of the stock market in 2008, huge amounts of cash have flowed into bond mutual funds over the past 36 months. The fact that very few large institutional investors and hedge funds have any desire for tax-free interest, and you can see an inordinately large group of sellers with very few buyers. Add in the fear and potential panic selling, and we could be in for a very difficult muni market. As an investor, I’ve been looking for good prices to get out of the bonds I hold, and finding smart, inflation-hedged investments to rotate into, such as floating rate bonds and real estate.

Timothy R. Lee, CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth, and on their Facebook page.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for individual. To determine which investment is appropriate, please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Strategies involving asset allocation and diversification do not ensure a profit or protect against a loss. Investing in real estate involves special risks such as potential illiquidity and property devaluation based on adverse economic and real estate market conditions, and may not be suitable for all investors. Even though Municipal bonds are federally tax-free, but may be subject to state and local taxes, and may be subject to the alternative minimum tax. Floating-rate bond interest income payments are subject to the fluctuation of current interest rates and is not predictable.

This post originally appeared at U.S. News & World Report.