Larry Swedroe: Munis Increasingly Risky

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Random Walker
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Larry Swedroe: Munis Increasingly Risky

Post by Random Walker »

https://www.etf.com/sections/index-inve ... nopaging=1

State and local pension liabilities are rising, government return assumptions are precariously optimistic (don’t make assumptions like these for your own retirement!), and default may not be so taboo anymore. Defaults are rare events, but the majority of them have occurred recently. Larry recommends only AAA, AA, and A (maturity < 3 years). He also recommends that regardless of rating, muni investments should only be in general obligation and essential service revenue bonds. Bonds are for dampening the risk we take elsewhere in the portfolio, so the bond investments should be safe. Larry enumerates several states to avoid, and comments that one should avoid bonds from those states even if the state is not the issuer.
Near the end, Larry cautions us that, unlike Treasuries, munis can correlate with the economy and stock market. Very important to only invest in high quality munis and take one’s risk elsewhere in the portfolio.

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Re: Larry Swedroe: Munis Increasingly Risky

Post by Valuethinker »

Random Walker wrote: Mon Nov 19, 2018 11:50 am https://www.etf.com/sections/index-inve ... nopaging=1

State and local pension liabilities are rising, government return assumptions are precariously optimistic (don’t make assumptions like these for your own retirement!), and default may not be so taboo anymore. Defaults are rare events, but the majority of them have occurred recently. Larry recommends only AAA, AA, and A (maturity < 3 years). He also recommends that regardless of rating, muni investments should only be in general obligation and essential service revenue bonds. Bonds are for dampening the risk we take elsewhere in the portfolio, so the bond investments should be safe. Larry enumerates several states to avoid, and comments that one should avoid bonds from those states even if the state is not the issuer.
Near the end, Larry cautions us that, unlike Treasuries, munis can correlate with the economy and stock market. Very important to only invest in high quality munis and take one’s risk elsewhere in the portfolio.

Dave
It's a genuinely useful piece - outlining the dangers.

Illinois, Kentucky, New Jersey. There's the immediate ones to worry about, particularly Illinois.

Perhaps if the crisis gets bad enough, the political system will be able to react to address the problems. However I suspect the crisis has to get really bad before that happens.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Random Walker »

It seems to me one can have one of two responses to the article.
1. More reason to maximize diversification by using a municipal bond fund
2. Take the specific advice when buying individual bonds

I’ve taken the second option. With individual bonds I can have higher average quality than bond fund, tailor the bond ladder to my specific state tax circumstance, take advantage of higher rate CDs at short end of ladder, avoid expense ratio of bond fund.

Dave
Last edited by Random Walker on Mon Nov 19, 2018 12:50 pm, edited 1 time in total.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by randomizer »

I was a bit queasy about muni risk so limited it to 50% off my bonds in own state until I got out.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by matjen »

The quick, EZ-Breezy solution to this issue is Baird Quality Intermediate Muni Bond Inst BMBIX

This fund will not return quite as much (assuming no crisis) but it is significantly safer than other intermediate term muni funds. 55% Advance Refunded and 75% AAA. If one believes in taking their risk on the equity side and having high quality bonds then this is an attractive option.

https://www.morningstar.com/funds/XNAS/BMBIX/quote.html

http://www.bairdassetmanagement.com/bai ... diate-muni
To achieve its quality and preservation of capital objectives, the strategy primarily invests in pre-refunded bonds, general obligations and essential service revenue issues.
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Random Walker
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Random Walker »

matjen wrote: Mon Nov 19, 2018 12:55 pm The quick, EZ-Breezy solution to this issue is Baird Quality Intermediate Muni Bond Inst BMBIX

This fund will not return quite as much (assuming no crisis) but it is significantly safer than other intermediate term muni funds. 55% Advance Refunded and 75% AAA. If one believes in taking their risk on the equity side and having high quality bonds then this is an attractive option.

https://www.morningstar.com/funds/XNAS/BMBIX/quote.html

http://www.bairdassetmanagement.com/bai ... diate-muni
That nearly combines my two options above :-) thanks Matjen

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Re: Larry Swedroe: Munis Increasingly Risky

Post by garlandwhizzer »

I wholeheartedly agree with Larry on these points. MUNIs are IMO only for those in very high income tax brackets and even then should be a very small portion of the bond portfolio and very carefully chosen to avoid these pitfalls. Taking increased duration/default risk has been rewarded in the bond market for multiple decades (except 2007-9) which has induced many investors to stretch for yield especially after taxes. No one can read the tea leaves that predict the market's future but I suspect that a time is coming in the near future when risk in the bond market will manifest itself in an ugly way for HYB and to some extent for non-HYB corporates and some MUNIs as well. The pension numbers are scary for some states and municipalities especially those with an eroding tax base. Important to remember that the first purpose for holding bonds is safety from market risk and volatility, not a promise of high after tax yield. With Treasury rates where they are at present, you aren't getting paid enough to take on this increased risk IMO.

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Re: Larry Swedroe: Munis Increasingly Risky

Post by Irisheyes »

Thanks for posting this.

I have invested in individual munis for many years. My recent strategy to counter the rising risk from underfunded pension obligations, etc, is to invest in AAA rated private university muni bonds like Stanford, MIT, etc. I figure the massive endowments behind these institutions coupled with their competitive advantage in terms of their intellectual business model will insulate them going forward despite what happens on the state level. I was gratified to see that, in the chart provided by Larry, only one private Univ. muni has defaulted in the last 46 years. I blithely ignore the duration warnings though so am exposed in that respect, and counter it with CDs on the short end.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by patriciamgr2 »

Thanks for posting this article.

Would someone clarify one point for me? Mr. Swedroe warns that some states' financial condition is so precarious, he worries about contagion impacting even highly-rated entities within that state. After listing the states whose GOs Buckingham won't buy, he writes: "(While we won’t buy the states’ GOs, we will buy other highly rated bonds from other issuers within the state.)"

How do you read that - for example, is a AAA rated issuer of essential service revenue bonds for a municipal sewer facility (located in Illinois) worth buying?

TIA for any help.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by kmurp »

Where does the Vanguard limited term tax exempt fund fit in with credit risk? It’s the only one I own.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by JackoC »

matjen wrote: Mon Nov 19, 2018 12:55 pm The quick, EZ-Breezy solution to this issue is Baird Quality Intermediate Muni Bond Inst BMBIX
Would be a no brainer IMO if the ER wasn't so high, 0.55% for investor share class. It's still worth considering though IMO, and worthwhile for you to have mentioned.

Re: the political/legal system coming up with a solution to the underfunded municipal/state employee pension/medical problem. It will, since it must. However part of that solution is now likely enough IMO to involve taking some of it out of the hides of 'rich' muni bond investors to cause concern. In 'likely' I'm speaking relatively. One could reasonably argue it's more likely than not no whole state has to resort to this. Some will almost surely avoid it. The problems being:
a) a worse outcome will correlate with long term bad stock market performance, exactly the scenario where one relies most on 'safe' assets.
b) 'not so likely' is a long way from 'riskless'. If it's even 10% chance of a big meltdown* that's a heck of a lot for a supposedly 'safe' asset.

*I'm not saying it's even that high. I don't know how likely it is. I do know there's no rational reason to think the past default performance of muni's is relevant to this new problem which basically didn't exist over the multi-decade data set people like to point to saying it's all OK. The Depression was bad, sure, but state and local govts were smaller fiscal entities then, hadn't made comparably generous financial promises to a comparable slice of the workforce, and didn't have big investments in the stock market trying to make enough money to make good on those promises. Different situation. Further back (wake of the Panic of 1837, in the early 1840's) a number of US states defaulted. Muni-optimists would correctly point out that was a different situation, but same goes for the 'even in the Depression...' argument about 20th century muni default rates.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by betablocker »

Good question. My first read was that he wouldn't recommend buying GO bonds of a municipality that is highly rated but in a low rated state: so if Evanston is AAA, he still wouldn't buy their GO bonds because Illinois is junk. My assumption is the other issuers are essential revenue bond issuers but would love clarification.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Northern Flicker »

It is not just default risk of muni bonds issued by agencies in a small number of states that a muni bond investor should worry about. If there are problems in one or more of those states, muni credit spreads are likely to widen considerably for bonds issued by agencies in many if not most other states, leading to a deterioration of market value even of muni bonds of higher credit quality.

While very high net worth investors may be able to hold a sufficiently diversified portfolio of munis to diversify credit risk, many if not most muni investors should either buy insured muni bonds or hold a diversified muni bond fund.

Bond insurance is primarily a diversification play— the bond insurer is able to insure across a diversified portfolio of munis because the insurance of assets of a large number of investors essentially is being pooled. The credit risk of the insurer is diversified across the credit risk of the insured portfolio, which is evaluated by ratings agencies when they rate the credit risk of the insurer.

Investors who live in a state with high income tax and who are not in a high federal tax bracket might prefer short-term TIPS or iBonds in taxable space.
Last edited by Northern Flicker on Mon Nov 19, 2018 8:40 pm, edited 2 times in total.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by JackoC »

kmurp wrote: Mon Nov 19, 2018 3:16 pm Where does the Vanguard limited term tax exempt fund fit in with credit risk? It’s the only one I own.
Vanguard muni funds have a typical cross section of credit for the muni market. That's the index, and they are basically index funds. A fund like BMBIX mentioned above has a significantly superior credit cross section than say VWIUX which is the Vanguard fund most comparable duration-wise. The idea sometimes mentioned on this forum about 'trusting' Vanguard managers to weed out particular bad issuers and thus insulate against the muni/pension problem is a misguided one. Maybe the problem isn't as serious as some think, but Vang fund managers are not going to insulate you from if it is. No knock on Vanguard.

The fund you mention has an avg stated maturity of only 3.5 yrs. It's also the only muni exposure I currently have and I'm comfortable with it. I'm considering, as I have some CD's maturing in the coming year, whether to replace them with other CD's or longer duration muni fund, ie VWIUX, or the safer but significantly higher ER BMBIX, and how I should compare after tax yields for the risk difference. I don't believe it's any longer a negligible risk difference. I would not consider long term muni funds now at all, though I'm not a fan of long duration in today's environment to begin with (negative term premium now per the NY Fed's model). And the longer muni funds are typically loaded with embedded call options: you're selling considerable rate optionality to get their higher yields, not just extending stated duration and credit risk.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by skeptical »

While muni defaults might be increasing, looking at Vanguard Intermediate National Muni (VWIUX), which is my major holding, shows it to be a pretty solid fund. I could not easily find any info from Vanguard (I guess I could call), however, a quick look at Morningstar and the data used as the basis for this article shows the default should be very low - low enough that the risk and/or cost of finding alternatives (BMBIX, rolling your own, etc) does not seem to be worth it.

Facts:
Article indicates that the housing sector is 40% of all defaults, VWIUX has a .6% exposure, cutting almost in half the default rate.
VWIUX combined Puerto Rico/Guam exposure: .26%, compare to 2% for even BMBIX
Article (exhibit 23) shows AAA/AA ratings have virtually no cumulative defaults over a 10 year period (0% for AA .02% for AA), which accounts for 82% of VWIUX exposure
“A" rating has a .07% 10 year default rate, with only an 18% exposure in VWIUX

A very rough calculation of weighted default averages and compensating for virtually no exposure to the housing sector would indicate that VWIUX has maybe a .01% cumulative default over a ten year period.

You can argue the details, overall, however, default risk is very low. Total Bond has far more default risk, even with only 26% in corporates.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by JackoC »

skeptical wrote: Mon Nov 19, 2018 4:06 pm While muni defaults might be increasing, looking at Vanguard Intermediate National Muni (VWIUX), which is my major holding, shows it to be a pretty solid fund. I could not easily find any info from Vanguard (I guess I could call), however, a quick look at Morningstar and the data used as the basis for this article shows the default should be very low - low enough that the risk and/or cost of finding alternatives (BMBIX, rolling your own, etc) does not seem to be worth it.

Facts:
Article indicates that the housing sector is 40% of all defaults, VWIUX has a .6% exposure, cutting almost in half the default rate.
VWIUX combined Puerto Rico/Guam exposure: .26%, compare to 2% for even BMBIX
Article (exhibit 23) shows AAA/AA ratings have virtually no cumulative defaults over a 10 year period (0% for AA .02% for AA), which accounts for 82% of VWIUX exposure
“A" rating has a .07% 10 year default rate, with only an 18% exposure in VWIUX

A very rough calculation of weighted default averages and compensating for virtually no exposure to the housing sector would indicate that VWIUX has maybe a .01% cumulative default over a ten year period.

You can argue the details, overall, however, default risk is very low. Total Bond has far more default risk, even with only 26% in corporates.
Has been very low, you mean. The thing to argue over isn't the details of past default performance of muni's. It's the relevance to the future situation of heavier reliance of municipal issuers on stock performance than anything seen in the past, for investors counting on munis to be the safe backstop if the stock market does very poorly for a long time. I would say that relevance is limited. A few readers of the forum might not realize that historical muni default rates are low. But I think most do, I do, I assume Larry Swedroe does (not that I'd take everything he's ever written as Gospel, but anyway I think he has something of a point here, not caused simply by being unaware of *past* muni default rates).
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Re: Larry Swedroe: Munis Increasingly Risky

Post by vineviz »

JackoC wrote: Mon Nov 19, 2018 4:21 pm Has been very low, you mean. The thing to argue over isn't the details of past default performance of muni's. It's the relevance to the future situation of heavier reliance of municipal issuers on stock performance than anything seen in the past, for investors counting on munis to be the safe backstop if the stock market does very poorly for a long time.
I agree to a point, but in essence you're making a "it's different this time" argument. You might very well be correct, but it's also important to keep in mind that long-term average default rates are indeed averages and include past crises as well as period of normalcy.

Swedroe makes, I think, some interesting qualitative points but what is really lacking is a quantitative analysis: things might get worse but HOW MUCH worse?

Corporate bond defaults provide some anecdotal guidance: from 1890 to 2008, the average annual default rate on corporate bonds was just under 1% (maybe 0.8% or so). During that period, however, there were about nine distinct "default cycles" or periods when default rates spiked to levels well above their long-term trend levels.

The worst default cycle was during the Great Depression when, over a five year period from 1931 to 1935 the default rate averaged 3.67% by NBER count. During the dot-com crisis the default rate averages 2.54% per year in 2001-2002, so let's say 3x or 4x their long-term average

Would it be crazy to imagine that, in worst-plausible-case scenario the muni bond default rate spikes to 3x, 4x, or 5x their "normal" rates for 2 or 3 or even 5 years in a row? Certainly not, but what are we talking about now? A CUMULATIVE muni default crisis of 0.25% of investment-grade munis. It'd get a lot of ink in the Wall Street Journal, but I don't see a coherent story that the average muni investor would take much of a financial hit.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by skeptical »

Has been very low, you mean. The thing to argue over isn't the details of past default performance of muni's. It's the relevance to the future situation of heavier reliance of municipal issuers on stock performance than anything seen in the past, for investors counting on munis to be the safe backstop if the stock market does very poorly for a long time.
Absolutely agree. The point I probably should have made is that, yes, muni's will probably get more risky if the economy does poorly, just when you want them to be safe, but they have a long way to go to become "unsafe", and if that is what is feared, you should not be in muni's or corporates at all (bond fund or custom ladders) and just hold treasuries.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by nisiprius »

Random Walker wrote: Mon Nov 19, 2018 11:50 am...unlike Treasuries, munis can correlate with the economy and stock market...
Blue: VTSMX, Vanguard Total Stock Market Index Fund (stocks)
Orange: VWITX, Vanguard Intermediate-Term Tax-Exempt Bond Fund (munis)
Green: VWAHX, Vanguard High-Yield Tax-Exempt Bond Fund (lower-grade munis)
Yellow: VBMFX, Vanguard Total Bond Market Index Fund (taxable bonds)
Dark red: VWEHX, Vanguard High-Yield Corporate Bond Fund (lower-grade taxable bonds)

Source
Image

I don't see anything bad happening to the Vanguard Intermediate-Term Tax-Exempt Fund during the last two stock market crashes, the second of which was definitely a recession. I don't see anything different in the behavior of tax-exempt (orange) and taxable (yellow) bonds during these stress periods.

VWITX is judged by Morningstar to be of "medium" credit quality, average credit quality "A", and it contains 5.02% bonds rated BBB, plus 1.58% unrated and lower-rated than BBB.

Looking at lower-quality bonds, VWAHX took a little more of a knock during 2008-2009, but it's nothing compared to what happened to the taxable, corporate bond fund. VWAHX has an average rating of BBB, is 19.78% BBB bonds, and a full 14.46% unrated and rated lower than BBB.

As for "correlation," neither of the municipal bond funds--neither the investment-grade VWITX nor the high-yield VWAHX, had a positive correlation with stocks (VTSMX)... unlike high-yield corporates (VWEHX) which did.

Source

Image

In short, using two Vanguard muni funds--one with credit quality lower than A--I didn't see "correlation with the economy and stock market" either in the form of visible dips or in correlation coefficients.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by matjen »

If you plug in Baird's BMBIX into the above you will see that it pretty much tracked Total Bond and did a fair bit better than Vanguard's Intermediate Term Fund VWITX during the global financial crisis. Over its lifetime (mid-2001) it has returned a bit more than Vanguard's VWITX. If there are no serious recessions I would expect it to return a bit worse.

Image
Last edited by matjen on Mon Nov 19, 2018 11:20 pm, edited 1 time in total.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by stlutz »

JackoC wrote: Mon Nov 19, 2018 3:22 pm
matjen wrote: Mon Nov 19, 2018 12:55 pm The quick, EZ-Breezy solution to this issue is Baird Quality Intermediate Muni Bond Inst BMBIX
Would be a no brainer IMO if the ER wasn't so high, 0.55% for investor share class. It's still worth considering though IMO, and worthwhile for you to have mentioned.
A cheaper alternative are the State Street ETFs, TFI & SHM, which have expense ratios of .23% and .20%, respectively. They are limited to AAA and AA bonds.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by stlutz »


Swedroe makes, I think, some interesting qualitative points but what is really lacking is a quantitative analysis: things might get worse but HOW MUCH worse?

Corporate bond defaults provide some anecdotal guidance: from 1890 to 2008, the average annual default rate on corporate bonds was just under 1% (maybe 0.8% or so). During that period, however, there were about nine distinct "default cycles" or periods when default rates spiked to levels well above their long-term trend levels.

The worst default cycle was during the Great Depression when, over a five year period from 1931 to 1935 the default rate averaged 3.67% by NBER count. During the dot-com crisis the default rate averages 2.54% per year in 2001-2002, so let's say 3x or 4x their long-term average

Would it be crazy to imagine that, in worst-plausible-case scenario the muni bond default rate spikes to 3x, 4x, or 5x their "normal" rates for 2 or 3 or even 5 years in a row? Certainly not, but what are we talking about now? A CUMULATIVE muni default crisis of 0.25% of investment-grade munis. It'd get a lot of ink in the Wall Street Journal, but I don't see a coherent story that the average muni investor would take much of a financial hit.
I'm not clear on why the high pension obligations don't just lead to crappy roads and higher taxes? If you are spending more money on pension benefits that leaves less for other things. It's a big jump to go from reducing services and raising taxes to default.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by garlandwhizzer »

The point isn't that Munis have been risky in the past. The point is that a minority of state and local governments have promised generous retirement benefits to current employees for lifetime inflation adjusted income and often full health insurance coverage. I'm not saying that employees should be shortchanged. Rather, the risk is that with ever increasing longevity and increasing medical costs this can produce huge demands on budgets that are already stretched. This was not a problem in 2007-9, but it may well be one in the future when more and more workers to retire and collect benefits. The easy way out of the problem of inadequately funded future liabilities is to assume high rates of investment returns going forward. That doesn't upset the voting public who are generally opposed to raising taxes. Nor does it upset employees who have been promised benefits. The problem with that is that many, probably most respected students of the market are projecting future returns in both bond and stock markets at significantly lower than historical average rates of return, the opposite of the robust returns some plans are assuming. Some Muni issuers are getting around this issue by investing for higher return in hedge funds, private equity, etc., the more exotic areas, but one need only look at the experiences of CALPERS to see how that can turn out.

I hope the numbers work out and that there will be no problem, but there is a very real possibility that some states/municipalities will find it unable to meet their obligations, not a large percentage but enough to shift market sentiment and produce a bit of worry if you have too much Muni exposure. If you choose to invest in Munis do your research, I suggest you buy carefully and conservatively, or else buy a Muni fund that is run by competent risk averse management that avoids problems before they happen.

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Re: Larry Swedroe: Munis Increasingly Risky

Post by ThrustVectoring »

Irisheyes wrote: Mon Nov 19, 2018 2:20 pm Thanks for posting this.

I have invested in individual munis for many years. My recent strategy to counter the rising risk from underfunded pension obligations, etc, is to invest in AAA rated private university muni bonds like Stanford, MIT, etc. I figure the massive endowments behind these institutions coupled with their competitive advantage in terms of their intellectual business model will insulate them going forward despite what happens on the state level. I was gratified to see that, in the chart provided by Larry, only one private Univ. muni has defaulted in the last 46 years. I blithely ignore the duration warnings though so am exposed in that respect, and counter it with CDs on the short end.
You can hedge against pure duration risk pretty cheaply through shorting Treasury futures, rather than averaging down with short-term products.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Northern Flicker »

Looking at lower-quality bonds, VWAHX took a little more of a knock during 2008-2009, but it's nothing compared to what happened to the taxable, corporate bond fund. VWAHX has an average rating of BBB, is 19.78% BBB bonds, and a full 14.46% unrated and rated lower than BBB
2008-2009 hit corporate credit especially hard because banks are large issuers of it. If a recession and equity bear originates with blowups in finances of some state and local govts, I would expect muni credit spreads to get hit harder, though it likely wouldn’t be a cakewalk for corporate credit either.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Theoretical »

One weakness of BMBIX now is that its prerefunded bond focus means a good chunk of the income will become taxable as post-2017 bonds start getting refunded under the new tax code.

I'm also increasingly concerned/alarmed by the amount of holdings in Illinois (including some not pre-refunded) and a couple of other states. It's still very conservative, but I think Munis have a lot of disadvantages they didn't used to possess, especially in a lower marginal rate tax world. It's a closer call in states with high state taxes, but in a place like Texas, unless you're making a bunch, treasuries and/or CDs are kind of the way to go.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by am »

I am increasingly concerned about investing in vanguards interm. Muni fund which I’ve done for years. It’s like I’m seeing a disaster coming closer and not doing anything about it. If stocks were falling, I’d be ok buying more. For some reason, I expect my bonds to be more stable. Primarily for short to interm, cash flow needs and for safety during hard times. What are others in high brackets doing who feel the same way?
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Re: Larry Swedroe: Munis Increasingly Risky

Post by mrspock »

am wrote: Mon Nov 19, 2018 9:26 pm I am increasingly concerned about investing in vanguards interm. Muni fund which I’ve done for years. It’s like I’m seeing a disaster coming closer and not doing anything about it. If stocks were falling, I’d be ok buying more. For some reason, I expect my bonds to be more stable. Primarily for short to interm, cash flow needs and for safety during hard times. What are others in high brackets doing who feel the same way?
I’m sitting in VCAIX (cali intermediate muni) and SUB (National Short Term muni). From what I have read, other folks who are worried are doing CDs and US treasury funds, and eating the taxes. The rationale is not to take any risk on the bond side. My approach had been to keep a close eye on the holdings of my two funds and watch questionable holdings. SUB does have some illinois in it, but no housing or health and is 85% AA or better. VCAIX has about 10% health and no housing and is about 80% AA or better.

To be honest, I’m not really sure what the right move is here..
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Re: Larry Swedroe: Munis Increasingly Risky

Post by hudson »

stlutz wrote: Mon Nov 19, 2018 7:31 pm
JackoC wrote: Mon Nov 19, 2018 3:22 pm
matjen wrote: Mon Nov 19, 2018 12:55 pm The quick, EZ-Breezy solution to this issue is Baird Quality Intermediate Muni Bond Inst BMBIX
Would be a no brainer IMO if the ER wasn't so high, 0.55% for investor share class. It's still worth considering though IMO, and worthwhile for you to have mentioned.
A cheaper alternative are the State Street ETFs, TFI & SHM, which have expense ratios of .23% and .20%, respectively. They are limited to AAA and AA bonds.
I agree with matjen on BMBIX; it fits L.Swedroe's AAA/AA criteria. Thanks stlutz; I didn't know TFI and SHM existed...useful information. TFI...longer; SHM...shorter.

https://us.spdrs.com/en/etf/spdr-nuveen ... nd-etf-TFI

https://us.spdrs.com/en/etf/spdr-nuveen ... nd-etf-SHM

Years ago, I split BMBIX (expense ratio = .3%) and VWIUX (expense ratio .09%). Every month I compared the distributions of each. The comparisons led me to go sour on BMBIX. I finally switched the BMBIX funds to a CD. I keep thinking that I need to go back. It's more likely that I'll dump everything back into VWIUX...and reach for a little yield. VWIUX is currently 68% AAA/AA, 23% A, and 9% other. BMBIX is 99% AAA/AA. BMBIX's TTM (average yearly distribution) is 2.4%; VWIUX's TTM is 2.92%.

https://www.morningstar.com/funds/XNAS/BMBIX/quote.html

https://investor.vanguard.com/mutual-fu ... olio/vwiux
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Re: Larry Swedroe: Munis Increasingly Risky

Post by nisiprius »

garlandwhizzer wrote: Mon Nov 19, 2018 8:04 pm...The point isn't that Munis have been risky in the past. The point is that a minority of state and local governments have promised generous retirement benefits to current employees for lifetime inflation adjusted income and often full health insurance coverage...
Why wouldn't that be reflected in the ratings of the bonds for those issuers? Perhaps there are fewer investment-grade municipals then before and more "high-yield" municipals than before, but why would an investor in investment-grade municipals need to change anything about what they are doing? Are you saying that the ratings agencies (NRSROs) are incompetent, or corrupt? Why wouldn't the SEC revoke their NRSRO status, then?
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Re: Larry Swedroe: Munis Increasingly Risky

Post by MikeG62 »

vineviz wrote: Mon Nov 19, 2018 5:15 pm
JackoC wrote: Mon Nov 19, 2018 4:21 pm Has been very low, you mean. The thing to argue over isn't the details of past default performance of muni's. It's the relevance to the future situation of heavier reliance of municipal issuers on stock performance than anything seen in the past, for investors counting on munis to be the safe backstop if the stock market does very poorly for a long time.
I agree to a point, but in essence you're making a "it's different this time" argument. You might very well be correct, but it's also important to keep in mind that long-term average default rates are indeed averages and include past crises as well as period of normalcy.

Swedroe makes, I think, some interesting qualitative points but what is really lacking is a quantitative analysis: things might get worse but HOW MUCH worse?

Corporate bond defaults provide some anecdotal guidance: from 1890 to 2008, the average annual default rate on corporate bonds was just under 1% (maybe 0.8% or so). During that period, however, there were about nine distinct "default cycles" or periods when default rates spiked to levels well above their long-term trend levels.

The worst default cycle was during the Great Depression when, over a five year period from 1931 to 1935 the default rate averaged 3.67% by NBER count. During the dot-com crisis the default rate averages 2.54% per year in 2001-2002, so let's say 3x or 4x their long-term average

Would it be crazy to imagine that, in worst-plausible-case scenario the muni bond default rate spikes to 3x, 4x, or 5x their "normal" rates for 2 or 3 or even 5 years in a row? Certainly not, but what are we talking about now? A CUMULATIVE muni default crisis of 0.25% of investment-grade munis. It'd get a lot of ink in the Wall Street Journal, but I don't see a coherent story that the average muni investor would take much of a financial hit.
I agree with this^
stlutz wrote: Mon Nov 19, 2018 7:35 pm
I'm not clear on why the high pension obligations don't just lead to crappy roads and higher taxes? If you are spending more money on pension benefits that leaves less for other things. It's a big jump to go from reducing services and raising taxes to default.
And this^
nisiprius wrote: Tue Nov 20, 2018 7:20 am
garlandwhizzer wrote: Mon Nov 19, 2018 8:04 pm...The point isn't that Munis have been risky in the past. The point is that a minority of state and local governments have promised generous retirement benefits to current employees for lifetime inflation adjusted income and often full health insurance coverage...
Why wouldn't that be reflected in the ratings of the bonds for those issuers? Perhaps there are fewer investment-grade municipals then before and more "high-yield" municipals than before, but why would an investor in investment-grade municipals need to change anything about what they are doing? Are you saying that the ratings agencies (NRSROs) are incompetent, or corrupt? Why wouldn't the SEC revoke their NRSRO status, then?
And this^ too.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by matjen »

nisiprius wrote: Tue Nov 20, 2018 7:20 am
garlandwhizzer wrote: Mon Nov 19, 2018 8:04 pm...The point isn't that Munis have been risky in the past. The point is that a minority of state and local governments have promised generous retirement benefits to current employees for lifetime inflation adjusted income and often full health insurance coverage...
Why wouldn't that be reflected in the ratings of the bonds for those issuers? Perhaps there are fewer investment-grade municipals then before and more "high-yield" municipals than before, but why would an investor in investment-grade municipals need to change anything about what they are doing? Are you saying that the ratings agencies (NRSROs) are incompetent, or corrupt? Why wouldn't the SEC revoke their NRSRO status, then?
Nisi, didn't this just happen 10 years ago? I mean wasn't much of the credit floating around highly rated...until it wasn't? I'm not suggesting a disaster or predicting future. Things like BMBIX or CDs are just ways for some to cut/lessen tail risk. Nothing wrong with the Vanguard muni funds at all (Or MUB or several others). Just a bit riskier.

A not so subtle take on their performance leading up to the global financial crisis courtesy of the Big Short.

https://www.youtube.com/watch?v=Kj2W_EqKzuw

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Re: Larry Swedroe: Munis Increasingly Risky

Post by wolf359 »

JackoC wrote: Mon Nov 19, 2018 3:33 pm
kmurp wrote: Mon Nov 19, 2018 3:16 pm Where does the Vanguard limited term tax exempt fund fit in with credit risk? It’s the only one I own.
Vanguard muni funds have a typical cross section of credit for the muni market. That's the index, and they are basically index funds. A fund like BMBIX mentioned above has a significantly superior credit cross section than say VWIUX which is the Vanguard fund most comparable duration-wise. The idea sometimes mentioned on this forum about 'trusting' Vanguard managers to weed out particular bad issuers and thus insulate against the muni/pension problem is a misguided one. Maybe the problem isn't as serious as some think, but Vang fund managers are not going to insulate you from if it is. No knock on Vanguard.

The fund you mention has an avg stated maturity of only 3.5 yrs. It's also the only muni exposure I currently have and I'm comfortable with it. I'm considering, as I have some CD's maturing in the coming year, whether to replace them with other CD's or longer duration muni fund, ie VWIUX, or the safer but significantly higher ER BMBIX, and how I should compare after tax yields for the risk difference. I don't believe it's any longer a negligible risk difference. I would not consider long term muni funds now at all, though I'm not a fan of long duration in today's environment to begin with (negative term premium now per the NY Fed's model). And the longer muni funds are typically loaded with embedded call options: you're selling considerable rate optionality to get their higher yields, not just extending stated duration and credit risk.
I believe the Vanguard muni funds are technically active funds. One indicator is that the index funds have the word "Index" in the title. Only some of the bond funds are labeled with "Index," and none of the munis.

It's also stated that they have a fixed income manager who advises the fund.

They do match the index very closely in terms of performance. I was listening to the Boglehead investing podcast recently (1st episode), and John Bogle mentioned something about the fact that they couldn't actually implement an index fund for munis (because they're too thinly traded.)

The following is how Vanguard is allocating their holdings by risk. They're roughly 70% AAA or AA. They're 90% AAA, AA or A. Its pretty conservative. If you checked their individual holdings over time, they stay away from the high risk stuff like Puerto Rico.

Vanguard Inter-Term Tax-Exempt Inv holdings

AAA 22.2%
AA 45.9%
A 22.6%
BBB 7.2%
BB 0.3%
B or Lower 0.5%
NR 1.3%
Total 100.0%
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Re: Larry Swedroe: Munis Increasingly Risky

Post by JackoC »

vineviz wrote: Mon Nov 19, 2018 5:15 pm
JackoC wrote: Mon Nov 19, 2018 4:21 pm Has been very low, you mean. The thing to argue over isn't the details of past default performance of muni's. It's the relevance to the future situation of heavier reliance of municipal issuers on stock performance than anything seen in the past, for investors counting on munis to be the safe backstop if the stock market does very poorly for a long time.
I agree to a point, but in essence you're making a "it's different this time" argument.
Sometimes it is different. :happy The pension problem obviously is different than past cases for muni's and less relevant still to corporate bond history (it's also questionable IMO to count longer term corporate bonds as non-risk assets in a stock heavy portfolio but that's another debate). But I didn't claim it was an easy problem to quantify. Hard to quantify however should not mean 'ignore' or 'assume it's OK' IMO.

Also I'd emphasize again the correlation issue. We are talking about the portion of a generally stock-heavy investor's (the great majority of people here by all appearances) portfolio they will be especially counting on if the stock market does poorly for an extended period. That's exactly when the more unfavorable possible manifestations of the pension underfunding issue would arise. That's true to some extent of credit generally, insofar as bad stock performance correlates with bad economic conditions thus lower tax revenue and higher social welfare expenses at all levels of govt. However with the pension thing there's also a direct connection now from stock market to pension underfunding caused by trying to fulfill pension promises via stock market investment (an argument might be made that govt's should fund future promises in riskless assets, or not make promises of future spending it can't fulfill at the riskless rate). It's a stronger correlation directly to the stock market.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by JackoC »

wolf359 wrote: Tue Nov 20, 2018 10:29 am
JackoC wrote: Mon Nov 19, 2018 3:33 pm
kmurp wrote: Mon Nov 19, 2018 3:16 pm Where does the Vanguard limited term tax exempt fund fit in with credit risk? It’s the only one I own.
Vanguard muni funds have a typical cross section of credit for the muni market. That's the index, and they are basically index funds.
I believe the Vanguard muni funds are technically active funds. One indicator is that the index funds have the word "Index" in the title. Only some of the bond funds are labeled with "Index," and none of the munis.

It's also stated that they have a fixed income manager who advises the fund.

They do match the index very closely in terms of performance.
Yes because the credit spectrum is basically that of the benchmark index. As opposed to a fund like BMBIX which has a quite different credit profile than comparable Vang fund. IOW I'm not seeing a substantive refutation of my statement 'they are basically index funds'. And I would reiterate my caution, though it could only apply to quite naive investors IMO, not to count on Vanguard fund managers to avoid suddenly arising widespread credit issues in a bond asset class. That's not really not their job. The investor is signing onto the risk of *basically* the muni index, which is what Swedroe's article is talking about. We're not talking about yield pigs bottom feeding the muni market.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Valuethinker »

vineviz wrote: Mon Nov 19, 2018 5:15 pm
JackoC wrote: Mon Nov 19, 2018 4:21 pm Has been very low, you mean. The thing to argue over isn't the details of past default performance of muni's. It's the relevance to the future situation of heavier reliance of municipal issuers on stock performance than anything seen in the past, for investors counting on munis to be the safe backstop if the stock market does very poorly for a long time.
I agree to a point, but in essence you're making a "it's different this time" argument. You might very well be correct, but it's also important to keep in mind that long-term average default rates are indeed averages and include past crises as well as period of normalcy.

Swedroe makes, I think, some interesting qualitative points but what is really lacking is a quantitative analysis: things might get worse but HOW MUCH worse?

Corporate bond defaults provide some anecdotal guidance: from 1890 to 2008, the average annual default rate on corporate bonds was just under 1% (maybe 0.8% or so). During that period, however, there were about nine distinct "default cycles" or periods when default rates spiked to levels well above their long-term trend levels.

The worst default cycle was during the Great Depression when, over a five year period from 1931 to 1935 the default rate averaged 3.67% by NBER count. During the dot-com crisis the default rate averages 2.54% per year in 2001-2002, so let's say 3x or 4x their long-term average

Would it be crazy to imagine that, in worst-plausible-case scenario the muni bond default rate spikes to 3x, 4x, or 5x their "normal" rates for 2 or 3 or even 5 years in a row? Certainly not, but what are we talking about now? A CUMULATIVE muni default crisis of 0.25% of investment-grade munis. It'd get a lot of ink in the Wall Street Journal, but I don't see a coherent story that the average muni investor would take much of a financial hit.
Muni defaults are not uncorrelated?

Before Detroit there had never been a default of that size? After all major cities did not go bankrupt?

(I am not sure where the Whoops default fits in - https://www.investopedia.com/ask/answer ... whoops.asp $2.225bn with a 10-40 cent recovery (not an inflation adjusted number)

Before Puerto Rico there had never been a default of that size? After all state-sized legal entities did not go bankrupt?

There are common underlying factors to these big defaults. And those factors are ongoing.

Past data, then, does not provide you with a good guide to future default rates?

It's quite possible default will be avoided. It's also possible that default will be entered into, as a way to force the different stakeholders - taxpayers, employers, pension recipients, employees - to the table. That would be the process of Chapter 11 in the private sector.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by JackoC »

nisiprius wrote: Tue Nov 20, 2018 7:20 am
garlandwhizzer wrote: Mon Nov 19, 2018 8:04 pm...The point isn't that Munis have been risky in the past. The point is that a minority of state and local governments have promised generous retirement benefits to current employees for lifetime inflation adjusted income and often full health insurance coverage...
Why wouldn't that be reflected in the ratings of the bonds for those issuers? Perhaps there are fewer investment-grade municipals then before and more "high-yield" municipals than before, but why would an investor in investment-grade municipals need to change anything about what they are doing? Are you saying that the ratings agencies (NRSROs) are incompetent, or corrupt? Why wouldn't the SEC revoke their NRSRO status, then?
I'm surprised you keep making that point in light of the issue with the ratings agencies on 'highly rated' mortgage backed securities and how well known it is, including by you I'm pretty sure. Perhaps you believe it was conclusively shown the agencies were either corrupt or incompetent in that case, in specific ways which are now fixed? Neither is really established AFAIK. And the basic accusation of conflict of interest, however valid it might be, is built into their business model, still. But just as plausibly that gross error might be explained by reasonably competent and non-corrupt people simply not factoring in as likely a case which soon arose, in the event.

Besides which, obviously and it's been stated many times in these discussions, it doesn't have to mean treating investment grade muni's as C-grade junk. It can mean simply adjusting targets for how much a muni has to beat a (federal govt risk) taxable alternative on an after tax basis. And/or, looking more askance at long term muni risk, which there are also other reasons to do anyway (today's negative term premium, looking more closely at the degree of call risk in long term muni funds). And/or upgrading one's credit spectrum including pre-refunded bonds (though sadly there is no really low cost fund doing this at the moment, BMBIX is rather high in ER by Vanguard standards).
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Re: Larry Swedroe: Munis Increasingly Risky

Post by garlandwhizzer »

matjen wrote:

A not so subtle take on their performance leading up to the global financial crisis courtesy of the Big Short.

https://www.youtube.com/watch?v=Kj2W_EqKzuw
1+

For those who believe that rating agencies or for that matter other aspects of the financial services industry are objective and reliable, the above 2 minute video should be required viewing. Conflict of interest pervades the financial industry. I believe it may be unwise to assume that because they are well educated, highly intelligent, and wearing a nice expensive suit you can believe and trust what they say. There is no way that a bundle of subprime mortgages given without evidence of income or assets to anyone capable of signing a document is anything but pure junk. How did it happen? The answer is simple: money. So much money flowed at every step of the process--to bankers who made these loans then promptly got them off their books, to the rating agencies who declared this worthless junk was in fact high quality fixed income based on their "models", to the financial industry which then bundled them into tranches and marketed them to legions of naive yield hungry investors, and of course to those who created and marketed complex exotic products like credit default swaps to bet on the outcome of these toxic products--so much money was flowing into so many pockets that its momentum proved irresistible until the house of cards collapsed. It was an entirely obvious disaster to anyone who took a serious look at it but no one did. They were very well paid not to. Instead the financial "professionals" in positions of authority at every step in the charade declared that everything was fine, reassuring investors and governmental mortgage agencies alike, that everything was just fine. Remarkably the vast majority of those who profited the most didn't buy their own products and walked away unscathed and quite rich after it fell apart.

It is IMO a mistake to assume that rating agencies or any other aspect of the financial industry gives consistently reliable objective financial advice/insight where a conflict of interest exists.

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Re: Larry Swedroe: Munis Increasingly Risky

Post by vineviz »

Valuethinker wrote: Tue Nov 20, 2018 12:00 pm
vineviz wrote: Mon Nov 19, 2018 5:15 pm
JackoC wrote: Mon Nov 19, 2018 4:21 pm Has been very low, you mean. The thing to argue over isn't the details of past default performance of muni's. It's the relevance to the future situation of heavier reliance of municipal issuers on stock performance than anything seen in the past, for investors counting on munis to be the safe backstop if the stock market does very poorly for a long time.
I agree to a point, but in essence you're making a "it's different this time" argument. You might very well be correct, but it's also important to keep in mind that long-term average default rates are indeed averages and include past crises as well as period of normalcy.

Swedroe makes, I think, some interesting qualitative points but what is really lacking is a quantitative analysis: things might get worse but HOW MUCH worse?

Corporate bond defaults provide some anecdotal guidance: from 1890 to 2008, the average annual default rate on corporate bonds was just under 1% (maybe 0.8% or so). During that period, however, there were about nine distinct "default cycles" or periods when default rates spiked to levels well above their long-term trend levels.

The worst default cycle was during the Great Depression when, over a five year period from 1931 to 1935 the default rate averaged 3.67% by NBER count. During the dot-com crisis the default rate averages 2.54% per year in 2001-2002, so let's say 3x or 4x their long-term average

Would it be crazy to imagine that, in worst-plausible-case scenario the muni bond default rate spikes to 3x, 4x, or 5x their "normal" rates for 2 or 3 or even 5 years in a row? Certainly not, but what are we talking about now? A CUMULATIVE muni default crisis of 0.25% of investment-grade munis. It'd get a lot of ink in the Wall Street Journal, but I don't see a coherent story that the average muni investor would take much of a financial hit.
Muni defaults are not uncorrelated?
Did I say that?

I’m not saying that the risks that people are mentioning aren’t real, nor that they might possibly manifest in a default crisis of some sort.

Instead, I’m saying that imagining a crisis is only really actionable if we have some estimate of both the likelihood and magnitude of such a crisis. Even if the next crisis was an order of magnitude greater that the worst previous crisis, I don’t see how investors in investment-grade municipalities are going to find their portfolios significantly affected.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Valuethinker »

vineviz wrote: Tue Nov 20, 2018 1:30 pm
Valuethinker wrote: Tue Nov 20, 2018 12:00 pm
vineviz wrote: Mon Nov 19, 2018 5:15 pm
JackoC wrote: Mon Nov 19, 2018 4:21 pm Has been very low, you mean. The thing to argue over isn't the details of past default performance of muni's. It's the relevance to the future situation of heavier reliance of municipal issuers on stock performance than anything seen in the past, for investors counting on munis to be the safe backstop if the stock market does very poorly for a long time.
I agree to a point, but in essence you're making a "it's different this time" argument. You might very well be correct, but it's also important to keep in mind that long-term average default rates are indeed averages and include past crises as well as period of normalcy.

Swedroe makes, I think, some interesting qualitative points but what is really lacking is a quantitative analysis: things might get worse but HOW MUCH worse?

Corporate bond defaults provide some anecdotal guidance: from 1890 to 2008, the average annual default rate on corporate bonds was just under 1% (maybe 0.8% or so). During that period, however, there were about nine distinct "default cycles" or periods when default rates spiked to levels well above their long-term trend levels.

The worst default cycle was during the Great Depression when, over a five year period from 1931 to 1935 the default rate averaged 3.67% by NBER count. During the dot-com crisis the default rate averages 2.54% per year in 2001-2002, so let's say 3x or 4x their long-term average

Would it be crazy to imagine that, in worst-plausible-case scenario the muni bond default rate spikes to 3x, 4x, or 5x their "normal" rates for 2 or 3 or even 5 years in a row? Certainly not, but what are we talking about now? A CUMULATIVE muni default crisis of 0.25% of investment-grade munis. It'd get a lot of ink in the Wall Street Journal, but I don't see a coherent story that the average muni investor would take much of a financial hit.
Muni defaults are not uncorrelated?
Did I say that?

I’m not saying that the risks that people are mentioning aren’t real, nor that they might possibly manifest in a default crisis of some sort.

Instead, I’m saying that imagining a crisis is only really actionable if we have some estimate of both the likelihood and magnitude of such a crisis. Even if the next crisis was an order of magnitude greater that the worst previous crisis, I don’t see how investors in investment-grade municipalities are going to find their portfolios significantly affected.
You are using past default rates to forecast future default rates? Hence my underlined bits. BTW an order of magnitude is 10x ;-).

Because of the way munis work, it's quite possible that a muni investor might be solely exposed to say Illinois muni bonds? I agree that if one holds a national muni bond fund, a default in say Illinois + collateral damage is not going to wreck you (although the drop in NAV could be pretty unpleasant).

Illinois is still investment grade - at the moment. It would be a big default - bigger than any previous. But this is where we get into systemic effects - events can make the default more likely. And if they do get into trouble, the spreads on the most risky bonds across the US will blow out. As I say, default may turn into a strategic way to get stakeholders to the table.

I am reminded we thought Greece could not default. Small state with fiscal problems, part of a currency union, would never be allowed to default (or so the theory went). I cannot remember whether we are now in default 3 or default 2, but another is almost certain (eventually).

We also thought that the US could not have a synchronized national housing downturn and that the system of mortgage finance, by transferring default risk onto the parties best placed to hold it (Michael Lewis's "the dumbest investors in the world were all based within 60 miles from Dusseldorf" ;-)). That didn't pan out so well, either.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by hudson »

garlandwhizzer wrote: Tue Nov 20, 2018 12:52 pm
matjen wrote:

A not so subtle take on their performance leading up to the global financial crisis courtesy of the Big Short.

https://www.youtube.com/watch?v=Kj2W_EqKzuw
1+

For those who believe that rating agencies or for that matter other aspects of the financial services industry are objective and reliable, the above 2 minute video should be required viewing. Conflict of interest pervades the financial industry. I believe it may be unwise to assume that because they are well educated, highly intelligent, and wearing a nice expensive suit you can believe and trust what they say. There is no way that a bundle of subprime mortgages given without evidence of income or assets to anyone capable of signing a document is anything but pure junk. How did it happen? The answer is simple: money. So much money flowed at every step of the process--to bankers who made these loans then promptly got them off their books, to the rating agencies who declared this worthless junk was in fact high quality fixed income based on their "models", to the financial industry which then bundled them into tranches and marketed them to legions of naive yield hungry investors, and of course to those who created and marketed complex exotic products like credit default swaps to bet on the outcome of these toxic products--so much money was flowing into so many pockets that its momentum proved irresistible until the house of cards collapsed. It was an entirely obvious disaster to anyone who took a serious look at it but no one did. They were very well paid not to. Instead the financial "professionals" in positions of authority at every step in the charade declared that everything was fine, reassuring investors and governmental mortgage agencies alike, that everything was just fine. Remarkably the vast majority of those who profited the most didn't buy their own products and walked away unscathed and quite rich after it fell apart.

It is IMO a mistake to assume that rating agencies or any other aspect of the financial industry gives consistently reliable objective financial advice/insight where a conflict of interest exists.

Garland Whizzer
I agree. The rating agencies can not be trusted. Everything that you said above happened...very ugly.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by DartThrower »

So Meredith Whitney wasn't wrong, she was just early?
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Re: Larry Swedroe: Munis Increasingly Risky

Post by vineviz »

Valuethinker wrote: Tue Nov 20, 2018 1:54 pm
vineviz wrote: Tue Nov 20, 2018 1:30 pm I’m not saying that the risks that people are mentioning aren’t real, nor that they might possibly manifest in a default crisis of some sort.

Instead, I’m saying that imagining a crisis is only really actionable if we have some estimate of both the likelihood and magnitude of such a crisis. Even if the next crisis was an order of magnitude greater that the worst previous crisis, I don’t see how investors in investment-grade municipalities are going to find their portfolios significantly affected.
You are using past default rates to forecast future default rates? Hence my underlined bits. BTW an order of magnitude is 10x ;-).
Yeah, when I said "order of magnitude" I meant that quite literally.

According to Moody's: "The five-year municipal default rate since 2007 was 0.15%, compared to 0.07% for the entire study period (1970-2016)."

What is the probability that an imminent municipal bond default crisis leads to default rates 10x an already-elevated 0.15%? Maybe 10%? Or possibly 25%? Is it as high as 50%?

Since 1970, the average rate of recovery from defaulted municipal bonds has been been about 66% (again according to Moody's). What is the probability that future recovery rates are half of historic rates (i.e. 33%)? Let's say that IF the default crisis occurs, there's a 50% chance of getting the historic recovery and 50% chance of recovery getting cut in half.

Now we're talking about a worst-case "municipal black swan" event that will cost investors somewhere between 0.25% and 0.75% of their municipal bond holdings on average.

Would this be a a big deal to gurus and portfolio managers? You betcha. Would it be a big deal to the typical investor? I hardly think so. Even if an investor was 50% in munincipal bonds, they are much more likely to be impacted by steel tariffs or Brexit than by pension funding levels in Illinois or New Jersey.

It's certainly possible that investors who are highly concentrated in certain issuers would be disproportionately hurt, and if this scary story helps frighten them into undertaking the diversification that (frankly) they should have known they needed already then all the better.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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Re: Larry Swedroe: Munis Increasingly Risky

Post by nisiprius »

vineviz wrote: Tue Nov 20, 2018 1:30 pmI’m not saying that the risks that people are mentioning aren’t real, nor that they might possibly manifest in a default crisis of some sort.

Instead, I’m saying that imagining a crisis is only really actionable if we have some estimate of both the likelihood and magnitude of such a crisis. Even if the next crisis was an order of magnitude greater that the worst previous crisis, I don’t see how investors in investment-grade municipalities are going to find their portfolios significantly affected.
Exactly. And, may I say, this issue comes up frequently when bonds are discussed, and I still don't know why. Magnitude matters. Even if you proved to me that bonds had +100% correlation with stocks, I would still use them in my portfolio if they had a third of the risk of stocks but half of the return of stocks.

The last time I remember "bond apocalypse" gurus talking about the size of the disaster was in 2010, when Jeremy Schwartz and Jeremy Siegel first said that there was a bubble in Treasuries that would have "far more serious consequences" than the year-2000 tech collapse... and then said, many paragraphs later and without performing the calculation for us, that the grim possibility was of a loss equal to three times the current yield--which calculates out to be -3 x 2.8% = -8.4%.

In other words, somehow, in their view, a hypothetical -8.4% drop in bonds would be "far more serious" than the -50% decline in stocks from 2000-2002.

For all I know, it might or might not be a shrewd incremental optimization to take some action in an portfolio with municipal bond holdings, but I doubt that it's any big deal.
Last edited by nisiprius on Tue Nov 20, 2018 3:18 pm, edited 1 time in total.
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Irisheyes
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Irisheyes »

DartThrower wrote: Tue Nov 20, 2018 2:05 pm So Meredith Whitney wasn't wrong, she was just early?
I just wish another Meredith Whitney would come along and make a similar "muni doom and gloom" pronouncement.

There were some great deals to be had in the muni market at that point. Most of the issues I picked up then have since been called, alas.
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nisiprius
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Re: Larry Swedroe: Munis Increasingly Risky

Post by nisiprius »

DartThrower wrote: Tue Nov 20, 2018 2:05 pm So Meredith Whitney wasn't wrong, she was just early?
No, she was wrong. Permanently wrong.

If a prediction does not include a time frame, it is not a prediction.

If a prediction includes a time frame and doesn't come true in that time frame, it is false. Permanently false.

Whitney said specifically:
"There's not a doubt in my mind that you will see a spate of municipal bond defaults," Whitney predicted.

Asked how many is a "spate," Whitney said, "You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults...."

"It'll be something to worry about within the next 12 months," she said.
Someday the Dow will almost surely reach 36,000, too but that will not make Glassman and Hassett right, because they didn't say "someday, eventually, the Dow will reach 36,000," they said
...36,000. How soon? The rational time frame is this afternoon. But the process will probably take longer as understanding spreads about the true risks of stocks. A sensible target date for Dow 36,000 is early 2005, but it could be reached much earlier.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Northern Flicker »

What is the probability that an imminent municipal bond default crisis leads to default rates 10x an already-elevated 0.15%? Maybe 10%? Or possibly 25%? Is it as high as 50%?
While I would not discount the possibility of a default crisis, I think a more plausible scenario is that we have an economic downturn caused by whatever it is caused by. It is associated with a global bear market in equities. The downturn also reduces tax receipts at the state and local level, while also reducing the asset levels backing state pension systems, exerting substantial pressure on state and local govt budgets. This would likely cause muni credit spreads to widen considerably, pushing down the market value (and draining liquidity) of muni’s precisely when they are needed to provide ballast against falling equity values.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Northern Flicker »

Incidentally, most state pension systems require public employers in a state to cover shortfalls for their retirees. The fees/contributions paid by the participating local agencies to the pension system can and typically will be increased when the pension system is strained to meet liabilities. Thus, an underfunded state pension can exert pressure on city, county, or school district budgets, and could be the tipping point that leads to a default by a particular local govt agency that is not the state govt.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by vineviz »

jalbert wrote: Tue Nov 20, 2018 2:51 pm
What is the probability that an imminent municipal bond default crisis leads to default rates 10x an already-elevated 0.15%? Maybe 10%? Or possibly 25%? Is it as high as 50%?
While I would not discount the possibility of a default crisis, I think a more plausible scenario is that we have an economic downturn caused by whatever it is caused by. It is associated with a global bear market in equities. The downturn also reduces tax receipts at the state and local level, while also reducing the asset levels backing state pension systems, exerting substantial pressure on state and local govt budgets. This would likely cause muni credit spreads to widen considerably, pushing down the market value (and draining liquidity) of muni’s precisely when they are needed to provide ballast against falling equity values.
You're probably right, but what would a muni spread crisis look like? Before 2008, investment grade municipal bonds traded at a discount to the yield of the 10-year Treasury. In 2008 the spread increased to a premium of 300 bps and now I think it's back down to about zero.

VTEAX has a duration of about 6 years, so a sharp widening to a 300bps premium would be an 18% drop in value relative to a treasury fund of similar duration. I'm sure that seeing a drop like that would be shock (it'd be similar to what happened in 2008, actually) and might be disruptive to investors wanting to rebalance from bonds back into stocks.
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Re: Larry Swedroe: Munis Increasingly Risky

Post by Northern Flicker »

18% is a painful drawdown for any asset class you hold for safety.

Interestingly, when Orange County defaulted in Dec. 1994, it was a non-event for the Vanguard intermediate-term tax exempt bond fund vwitx:

https://www.portfoliovisualizer.com/bac ... ion1_1=100
Risk is not a guarantor of return.
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