The financial crisis of the last four years has damaged the financial conditions of cities and states—and municipal bond insurers. In our view, this has increased the value of research and undermined individual investors’ classic approach to municipal bonds: laddering. My colleague Guy Davidson explains why, below and in the Reuters muniland blog.
The Problem with Ladders
Laddering entails buying bonds with a range of maturities and holding them to maturity. In our view, it has always left potential gains on the table that an active manager can scoop up, but the strategy has become especially problematic now.
Before 2008, about half of newly issued bonds came to the market as AAA-insured bonds. This made it appear fairly safe for individuals or their advisors to choose among the wide array of available bonds.
But several major bond insurers went out of business in the last few years after expanding into the subprime mortgage market. As a result, only about 5% of the municipal bonds issued so far this year are insured, and the pool of AAA-rated municipal bonds has fallen dramatically. Individual investors can no longer rely on a AAA rating for safety. The bonds simply aren't there.
So now more than ever you have to understand the credit particulars of the bonds you buy—and that entails detailed research into a vast array of bonds. The major municipal bond indices include between 27,000 and 47,000 securities of various maturities and features, issued by about 2,500 entities. Compare that with the 500 stocks in the S&P 500 and the approximately 1,500 stocks in the Morgan Stanley Capital International World Index.
A Simpler Path?
There's another weakness to laddering and buy-and-hold strategies. All of them rest on the principle that as long as the issuer doesn’t default, investors are assured of getting regular interest payments and 100% of their principal back when the bonds mature, regardless of whether the value climbs or falls during the life of the bond.
But bond values constantly change in response to market conditions, so locking into a bond or group of bonds means losing out on the higher returns that may be available as interest rates rise, credit conditions shift or the shape of the yield curve changes. In essence, it means forfeiting potential return opportunities and ignoring potential risks.
Active managers can add value by exploiting these changes. Bonds, like stocks, offer potential capital appreciation (or loss), as well as income; total after-tax return is a combination of all these factors. Bond investing may appear to be as simple as buying bonds with the highest yield, but there’s far more to it, especially in today’s world.
The financial crisis taught us that financial conditions can change both quickly and dramatically. Investors should be in a position to adapt and profit from changing conditions.
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