INSIGHTS

On April 28, 2014

Viewpoints from AAM - Push the Limits of Your Fear: A Municipal Perspective

Over the history of the municipal bond market there have been many circumstances that created overwhelming fear with investors rushing to the exits and selling their holdings at any cost, an action we view as “irrational” investor behavior. Detroit and Puerto Rico instilled such fear in 2013. The same can be said about California a few years back. In fact, many bonds have been shunned or boycotted at any price, at one time or another.

If people were able to eliminate emotions from their investment decisions and instead focus on the realities of the municipal bond market, they would likely realize that buying credits others are throwing overboard may be a good way to potentially enhance total return. Keep in mind I am referencing large investment grade issuers and not small, non-investment grade offerings. According to a Moody’s default study in 2013, municipal defaults averaged 0.012% over a 43-year study of investment grade municipal bonds and had a recovery rate of approximately 65%. According to this study, a good argument can be made that investors potentially lose more money in “irrational” liquidations than due to price declines in response to a perceived credit weakness and possibly even a bankruptcy.

A good example of this would be Puerto Rico general obligation bonds with a 5.25% coupon maturing in 2016. At the height of the panic, individual investors were selling bonds at approximately 11.50%-12% yields for a 3-year bond. This was happening while the Governor of Puerto Rico promised that bankruptcy was not an option and was doing all he could to turn the island’s fortunes around. In the meantime, sales of new issuance bond deal worth $3.5 billion was much stronger than expected, and could be beneficial to the likelihood the bonds maturing in 2016 would be paid off in full. If the 2016 bonds were purchased when everyone was selling and were held to maturity, the total return potential would be compelling at approximately 25%, even if interest rates spike higher.

Another example is California municipal bonds, which were experiencing some pressure a few years back due to its sluggish economy. Many investors either liquidated their holdings without regard to value or mandated that their investment managers not purchase any California credits in their managed accounts. This caused California prices to cheapen and credit spreads to widen to over 100 basis points. California is a diverse state with many tools at its disposal to strengthen its credit profile. Over the last few years the economy has been improving, as is its credit profile. The bonds most individual investors did not want when they were trading at unprecedented spreads recently came to market at the relatively richest price and tightest spreads ever. If investors could have overcome their fear they could have potentially participated in some of the best performing bonds over the past few years.

While these are only two examples, there are many more. Panic-induced selling is never a good idea and often adds to losses even in a declining interest rate environment. If investors could push their limits of fear and buy when others are selling, they may benefit from higher long-term return.

CRN: 042414-4158R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Municipal Disclosures webpage. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com