Municipal debt, Detroit, and diversification

Posted by on December 3, 2013 @ 2:00 pm in Investing

There’s no question that the municipal bond market has been on a roller coaster this year. In July, news of Detroit filing for the largest municipal bankruptcy in history roiled the markets, seeing investors sell municipal bonds and yields on even highly rated issuances rise. And just recently the bankruptcy court ruled that Detroit is eligible for Chapter 9 bankruptcy protection. In September, the bond markets saw a huge rally on the back of the Fed’s decision not to taper. And in October, the sustained economic decline in Puerto Rico produced further turmoil, which resulted in selling of Puerto Rico bonds and an inability of the territory to borrow on the public markets, followed next by a comeback in the markets that led to even higher volatility. Combined with questions about when the Fed will actually slow down its bond buying, a lot of volatility in the asset class continues.

In times like these, it can be difficult to see the forest for the trees. Headlines like “Largest municipal bankruptcy in history,” “Game-changing restructuring,” and “Bonds are over” definitely grab our attention. If we aren’t disciplined, emotion can drive our investing behavior, pushing us to make decisions based on front-page news. And yet, it’s during these times when long-term planning and seeing the big picture matter the most.

It’s probably time for a confession: I love to read financial news. One of my favorite things to do is read the business headlines, dive into the details, and contemplate all the nuances. These qualities make me very popular at cocktail parties. But when it comes to investing, I (unsurprisingly) find that the most complicated problems always lead me back to the basics. When issues are complex, simplicity matters most. And on this, Vanguard’s principles for investing success bring us back to the big picture. So let’s pause, step back, and remind ourselves what we’re doing.

Create clear, appropriate investment goals

Vanguard’s first investment principle tells us that defining our goals clearly and being realistic about how to achieve them can protect us from common mistakes that derail progress. Those mistakes include chasing returns and basing your investment selections on “transitory factors.” So while it’s hard to know what’s “transitory” and what’s not, we know that our goals shouldn’t change very often, and certainly not without careful thought.

This principle also reminds us that because most objectives are long-term, a plan should be designed to endure through changing market environments. Why? Because while paying close attention to an investment may seem logical, it can lead investors to fall into avoidable mistakes such as reacting to headline news. Our research shows that without a clear plan, investors can be tempted to invest based on short-lived factors. Here’s an example:

 Figure 1. 30-year muni yield vs. industry cash flow

Figure 1. 30 year muni yield vs industry cash flow

Source: Morningstar

Figure 1 shows the 30-year municipal bond yield versus industry cash flow. Suppose you made an investment in tax-exempt bonds 10 years ago, when the yield hovered around 5%. In December 2010, Meredith Whitney made her prediction of “hundreds of billions of dollars of defaults” in the muni market. If you had sold tax-exempt bonds just after that call, you would have missed out on the tremendous rally in the market that subsequently took place. By trying to time trading around the headlines, you could have realized significant losses and paid even more in terms of transactions costs.

Chris Alwine, who oversees Vanguard’s municipal bond operations, captured this sentiment in a recent podcast: “I do want to caution [investors] about ‘jumping in.’ Jumping in implies a market-timing component, and market timing is very challenging because it requires two correct calls: when to get in and when to get out.” The point is, there’s no guaranteed way to time trades based on headline news. Better instead to stick with your long-term investing plan and let it do the work.

Develop a suitable asset allocation using broadly diversified funds

Using diversified investments can help avoid exposure to unnecessary risks. While there are many types of diversification, the idea is simple: Diversifying within an asset class (in this case, municipal bonds) reduces exposure to risks associated with a particular segment (in this case, municipal issuers). Consistent with this idea, let’s take a look at the diversification of Vanguard’s Intermediate-Term Tax-Exempt Fund.

Figure 2. Percentage of assets in top 10 holdings of Vanguard Intermediate-Term Tax Exempt Fund versus the 10 largest tax-exempt bond funds

 

Source: Morningstar

Source: Morningstar

Figure 2 shows the percentage of assets in the top 10 holdings in the Vanguard Intermediate-Term Tax Exempt Fund versus the next 10 largest tax-exempt bonds funds. From this visual, it’s striking to grasp the level of broad diversification in Vanguard’s fund. Moreover, one can see how difficult it would be to achieve this same level of broad diversification using, for example, a bond ladder*, which would require the labor-intensive practice of individual credit analysis, security selection, and ongoing management. Therein lies the genius of broad fund diversification: It protects us from any one negative event and affords us the benefits of professional credit analysis and portfolio management.

Minimize cost

Attention-grabbing headlines are designed to seize us—to lead us to click on that article and pore over the details. And yet, in so doing, it’s easy to forget that we can’t actually control any of these events. So we must keep in mind that, as investors, there’s only one variable that we can control: cost. The lower our costs, the greater our share of an investment’s return. Research shows that lower-cost mutual funds have tended to perform better than higher-cost funds over time. So instead of worrying about things we can’t control (e.g., how a judge in a municipal bankruptcy is going to decide a case), we should focus on controlling the one variable that we can, which is cost.

Figure 3. Net fund expense ratios compared to 5-year annualized returns

Source: Morningstar

Source: Morningstar

Figure 3 demonstrates the power of low-cost investing. It shows the net fund expense ratios of municipal bond funds compared to their 5-year annualized returns. The relationship is clear: Lower expense ratios are positively correlated with higher returns. Again, as Chris Alwine has stated, “Cost is a big driver of return in fixed income products in particular, and [you should] understand the costs that you’re paying to invest in a specific mutual fund.”

Maintain discipline and a long-term perspective

This final investing principle is perhaps the most powerful of all—and yet it might also be the most difficult. It’s the one that tells us that in the face of market turmoil, even the “largest municipal bankruptcy filing in history,” we must avoid “rubberneck syndrome” and maintain discipline and a long-term perspective, lest we get caught in the wreck. In truth, it requires some fortitude to remain committed to a long-term investment program. But if we are successful—if we ignore the temptation to abandon our plans in the face of temporary headline news—the long-term rewards will be worth it.

Many thanks to Chris Alwine, Josh Hirt, Michael DiJoseph, and Fran Kinniry for their expertise on this blog

 

*Bond ladder:  A bond ladder refers to a portfolio of fixed income securities in which each security has a different maturity date.  Generally, the bonds’ maturity dates are evenly spaced across several months or years so that the bonds are maturing at regular intervals.

 

Notes:

  • All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
  • Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

 

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