Investing in lower quality munis or muni funds.

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ilan1h
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Investing in lower quality munis or muni funds.

Post by ilan1h »

I was speaking to a bond advisor at Schwab and he was suggesting the possibility of considering intermed term munis that were medium grade rated (I think BBB+). This is in contrast to Vanguard's interm muni funds which are much higher rated. He was explaining that at the beginning of a recession people tend to gravitate to highly rated fixed income. However, in the second part of a recession (when optimism is building) people are willing to take on some more risk. He suggested that the risk spread was such that one could eke out another 2% of yield by going with these medium grade ratings. Does this sound reasonable?
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David Jay
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Re: Investing in lower quality munis or muni funds.

Post by David Jay »

You have been around since the beginning of BH. Surely you know the expression: “Take your risk on the stock side”.

There simply is no yield out there in this low-interest-rate environment. We just need to live with it. People are making serious mistakes as they grasp for yield.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius
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ilan1h
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Re: Investing in lower quality munis or muni funds.

Post by ilan1h »

That was my gut feeling too. I'll stick to the safe stuff with the diminishing yields for now. If i want to take on risk I'll do it on the stock side.
backpacker61
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Re: Investing in lower quality munis or muni funds.

Post by backpacker61 »

I have an investment in Vanguard High-Yield Tax-Exempt Fund Admiral Shares (VWALX).

Morningstar actually rates it as a long term tax exempt fund because it doesn't delve very far into the true "high yield" portion of the muni market. You can read the Morningstar review at many public libraries (I log in to my community libraries' web site and can access Morningstar through that).

The expense ratio is nice and low, too.
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JackoC
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Re: Investing in lower quality munis or muni funds.

Post by JackoC »

David Jay wrote: Fri Oct 16, 2020 10:55 pm You have been around since the beginning of BH. Surely you know the expression: “Take your risk on the stock side”.

There simply is no yield out there in this low-interest-rate environment. We just need to live with it. People are making serious mistakes as they grasp for yield.
I generally agree or at least, if people stick with very safe investments on the 'safe' side and 'take risk on the stock side', the missed opportunity if any will probably be marginal. There's more downside in convincing oneself 'investment grade' means 'riskless'.

And the problem goes beyond that with 'investment grade' bond *indexing*. Ilmanen in "Expected Returns" quoted the following. The Lehman/Barcap corporate bond index had an average option adjusted ex-ante yield spread* of 1.20% over comparable maturity treasuries in 1973-2009, but the actual return advantage over treasuries in that period was only 0.30%. There were various reasons for that like the index dropping bonds when they reached a minimum maturity (whereas risk/return was often best for short maturity IG corporate bonds) and direct default from investment grade, but the biggest seemed to be when the index dropped bonds downgraded to junk. That avoided most outright defaults within the index, but still cost.

What these numbers might be for muni's is somewhat uncertain but generally similar problems are likely if the rating spectrum is similar. Vang's 'high yield' muni fund VWALX is ~65% A rated and above so not comparable to a typical high yield corp fund; not even Vang's relatively low yielding/highly rated corp junk fund VWEAX which is ~55% BB (BB had the best risk/return performance historically among corporates per same source as above). But if a muni fund was heavily into BBB bonds you could expect it to be seriously bruised by a wave of downgrades. Most muni funds are technically active, they shadow indexes but give managers more leeway to keep downgraded bonds but still. If you held a DIY portfolio of BBB muni's you could choose to keep them all to maturity or default regardless of downgrade. Historically for corporates that would have raised return notably v IG corp index return. But then it's obvious the strategy is not really 'investment grade' in the long run, it's an IG/junk mix over time. And with a starting point of all BBB it could be a lot of junk if there's a wave of muni downgrades.

One upside of a junk bond allocation is that the pretense it doesn't have credit risk is implausible (maybe measuring that risk's impact on portfolio is a little tricky, and if felt too complicated then forget it, no problem). The pernicious aspect of 'investment grade', especially near the margin at BBB, is if the investor pretends IG= 'riskless'.

*IOW basically if you compared the SEC Yield of a fund to the comparable treasury, but after subtracting from the SEC yield the value of issuer call options, which few investors do, another problem with 'investment grade' bond funds: not accounting for the extra rate risk you're taking for a given apparent duration because that duration with lengthen relative to non-callable (callable treasuries once existed but no longer) as rates go up, shorten relatively as rates go down. Some bond fund sponsors offer an option adjusted spread number for their funds but Vanguard, which still tends to have a strong advantage in expenses on bond funds, does not.
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Re: Investing in lower quality munis or muni funds.

Post by grabiner »

JackoC wrote: Sat Oct 17, 2020 10:13 am One upside of a junk bond allocation is that the pretense it doesn't have credit risk is implausible (maybe measuring that risk's impact on portfolio is a little tricky, and if felt too complicated then forget it, no problem). The pernicious aspect of 'investment grade', especially near the margin at BBB, is if the investor pretends IG= 'riskless'.
From S&P, 10-year corporate default rates, 1981-2019:
https://www.spglobal.com/ratings/en/res ... y-11498915

Code: Select all

Grade Rate
AAA   0.84%
AA    1.09%
A     1.95%
BBB  4.75%
BB   15.93%
B     29.44%
CCC-C 56.73%


So there is a significant difference between BBB and A, and it is most likely to show up when your other investments are losing value. This is why the yields on Vanguard's corporate indexes, which are more than half BBB bonds, are significantly higher than the yields on other bond funds.
Wiki David Grabiner
JackoC
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Re: Investing in lower quality munis or muni funds.

Post by JackoC »

grabiner wrote: Sat Oct 17, 2020 3:48 pm
JackoC wrote: Sat Oct 17, 2020 10:13 am One upside of a junk bond allocation is that the pretense it doesn't have credit risk is implausible (maybe measuring that risk's impact on portfolio is a little tricky, and if felt too complicated then forget it, no problem). The pernicious aspect of 'investment grade', especially near the margin at BBB, is if the investor pretends IG= 'riskless'.
From S&P, 10-year corporate default rates, 1981-2019:
https://www.spglobal.com/ratings/en/res ... y-11498915

Code: Select all

Grade Rate
AAA   0.84%
AA    1.09%
A     1.95%
BBB  4.75%
BB   15.93%
B     29.44%
CCC-C 56.73%

So there is a significant difference between BBB and A, and it is most likely to show up when your other investments are losing value. This is why the yields on Vanguard's corporate indexes, which are more than half BBB bonds, are significantly higher than the yields on other bond funds.
True but again you also have to consider that a lot of the effective credit loss in 'investment grade' index return is bonds being downgraded below BBB and kicked out of the fund at a loss. The %'s given are default if the bonds were held to maturity or default whichever came first. Investment grade funds will avoid a lot of those defaults by selling bonds that become junk, but that's also a drag on return especially since most bonds downgraded to junk don't end up defaulting. Historically, getting rid of bonds which transitioned below BBB cost noticeably more across the whole index than riding it out to maturity or default. For example if 1.95% of A bonds defaulted the great majority became junk bonds first, direct default from even A is rare, and a multiple of that % of A bonds became junk but didn't default. Also, defaulted bonds are seldom worth zero, $0.40 on the $1 is the very rough rule of thumb.

Moody's/S&P also have historically based transition matrices, the probability based on history say a BBB now will become A, BB, AA, or B etc. the following year, for each rating. Although to model the effect on index return you'd also need to know price change given downgrade (and actually the market reacts to all facts it learns about credit not just rating agency actions). Moodys/S&P also have loads of data for prices after default (but again that's complicated by whether you assume the bond is sold to a 'vulture' upon default, or *you're* the vulture seeing it through to final recovery by bondholders when the company is liquidated or re-emerges with the creditors as the owners) by type of bond and company.

Bonds with the exception of treasuries are generally more complicated than stocks, a seeming irony that comes into focus particularly when investors seek 'a little more yield by taking a little more risk'.
GaryA505
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Re: Investing in lower quality munis or muni funds.

Post by GaryA505 »

I have almost all of my taxable account in VWALX and I like it. I know that a 80/20 mixture of VWIUX/VTSAX would historically have produced slightly better returns with smaller drawdowns, but the dividends from VTSAX would not be tax exempt so to me it's about the same.

https://www.portfoliovisualizer.com/bac ... tion3_2=20
000
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Re: Investing in lower quality munis or muni funds.

Post by 000 »

I don't see why risk should only be taken on the stock side. I don't see a particular connection between the forward-looking risks of low quality munis and stocks. In fact, because the US index is so highly concentrated in a handful tech companies and a lot of state/municipal revenue comes from non-internet activities, they would seem to be somewhat uncorrelated sources of risk.

In what kind of world do stocks AND low quality munis fail? I'm guessing one where you need land, arms, and metals; not stocks or bonds.

Of course, I wouldn't expect low quality munis to retain liquidity during a liquidity event.
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ilan1h
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Re: Investing in lower quality munis or muni funds.

Post by ilan1h »

In the june edition of Vanguard Perspectives they discuss "Three reasons why muni bonds look appealing now". One of the reasons they give is "Lower-quality muni bonds are adequately compensating investors for risk." They state that before the pandemic credit spreads were tight, providing little extra yield for A and BBB or revenue bonds. However, as of April BBB spreads were about 150bp wider and double their historical average spread. Apparently this spread continues and at the beginning of October there was a spread of 313bp between high yield and AAA. I took a look at the Vanguard HY Tax exempt adm fund and only 35% BBB or lower. By contrast VCADX (CA int. muni) has less than 6% BBB or lower. The HY fund did somewhat better over the last 20 yrs but not by a stretch. Returns after taxes since 2001 was 4.78% for the HY compared to 4.36 for VCADX. And yet the overall ride was rockier for the HY fund with a higher SD and double the Max. drawdown (11% vs 5%). The worst year was 5X worse for HY (10% vs. 2%). Seems to me that overall the higher quality muni was the better investment.
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Re: Investing in lower quality munis or muni funds.

Post by Scooter57 »

To get really simple here, why would your advisor know we were in the second part of a recession?

We have never before had a stressor on our economy like this pandemic. It is very far from over. I have some; expertise in interpreting medical research and nothing I read in the journals suggests that a vaccine will end the disruptions we are undergoing

Munis include bonds whose interest and principal are paid from the income of stadiums, airports, colleges, parking garages, and other projects that are looking at dramatic, continuing, loss of income.The ratings on muni bonds are not updated regularly AMD may not capture these new stresses.. With sustained unemployment the income sourced needed to fund all muni bond payments will come under pressure.They may well be less safe than high yield corporate bonds right now.
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Re: Investing in lower quality munis or muni funds.

Post by 000 »

Scooter57 wrote: Sat Oct 17, 2020 8:26 pm To get really simple here, why would your advisor know we were in the second part of a recession?

We have never before had a stressor on our economy like this pandemic. It is very far from over. I have some; expertise in interpreting medical research and nothing I read in the journals suggests that a vaccine will end the disruptions we are undergoing

Munis include bonds whose interest and principal are paid from the income of stadiums, airports, colleges, parking garages, and other projects that are looking at dramatic, continuing, loss of income.The ratings on muni bonds are not updated regularly AMD may not capture these new stresses.. With sustained unemployment the income sourced needed to fund all muni bond payments will come under pressure.They may well be less safe than high yield corporate bonds right now.
As all of that is publicly known, doesn't that make them a juicy value buy?

Don't tech stocks provide diversification from the "dramatic, continuing, loss of income [of local government projects]" scenario?
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Re: Investing in lower quality munis or muni funds.

Post by Scooter57 »

No. A value buy in investing, by definition, is an investment whose price fails to recognize the value of the earning powet of the company that issues it. Unless you are convinced the economy will rebound very quickly there are no hidden gems here.

These bonds are most likely more risky and less valuable than their prices suggest because ignorant retail investors look only at the yield and are not aware of the risks. Retirees are so desperate for income with treasuries and CDs paying less than 1% that they will buy these funds and push up their prices. Then at some future time we will hear in the media about how utterly unrxpected it was when the wave of bond defaults hits and destroys the retirees' nest eggs. It is only a surprise if you don't think things through.

Bonds prices are not a random walk. They are well understood and their value depends entirely on issuers being able to service and repay their debts.
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Re: Investing in lower quality munis or muni funds.

Post by 000 »

Scooter57 wrote: Sat Oct 17, 2020 8:59 pm No. A value buy in investing, by definition, is an investment whose price fails to recognize the value of the earning powet of the company that issues it. Unless you are convinced the economy will rebound very quickly there are no hidden gems here.

These bonds are most likely more risky and less valuable than their prices suggest because ignorant retail investors look only at the yield and are not aware of the risks. Retirees are so desperate for income with treasuries and CDs paying less than 1% that they will buy these funds and push up their prices. Then at some future time we will hear in the media about how utterly unrxpected it was when the wave of bond defaults hits and destroys the retirees' nest eggs. It is only a surprise if you don't think things through.

Bonds prices are not a random walk. They are well understood and their value depends entirely on issuers being able to service and repay their debts.
No, there can be a value buy in bonds if credit risk is overappreciated by the market, i.e. the actual credit risk is less than the market is pricing it.

Although I tend to agree with you on the yield chasers, there seems to be a lot of earnings chasers too right now.
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ilan1h
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Re: Investing in lower quality munis or muni funds.

Post by ilan1h »

Scooter57 wrote: Sat Oct 17, 2020 8:26 pm To get really simple here, why would your advisor know we were in the second part of a recession?

We have never before had a stressor on our economy like this pandemic. It is very far from over. I have some; expertise in interpreting medical research and nothing I read in the journals suggests that a vaccine will end the disruptions we are undergoing

Munis include bonds whose interest and principal are paid from the income of stadiums, airports, colleges, parking garages, and other projects that are looking at dramatic, continuing, loss of income.The ratings on muni bonds are not updated regularly AMD may not capture these new stresses.. With sustained unemployment the income sourced needed to fund all muni bond payments will come under pressure.They may well be less safe than high yield corporate bonds right now.
They don't like us to discuss coronavirus topics on this board so I will avoid specifics. Nonetheless, I don't think it's unreasonable for him to point out that we are in a far better place now than we were in March. Of course, anything can happen and we are not out of the woods but most people are pretty sure that we are in a better situation now. So it would not be unreasonable to project that confidence levels will increase, consumer behavior will resume and all that should be reflected in the various markets.
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Re: Investing in lower quality munis or muni funds.

Post by Scooter57 »

Most people believe what they hope is true or what they are told by people who profit by having them believe what they say.

The bond market was signaling recession last year, back when "Corona" was just Tony Romo's beer. Liquidity froze up in the repo market early last winter forcing the Fed to intervene massively, something I had never seen before.

The introduction of widespread free stock trading has changed market dynamics in a way that academics are just beginning to understand, but it is a major factor causing the market to detach from reality in a way that historically leads to trouble. Looking at what happened to muni bond prices in March should disabuse you of the idea that they don't correlate with the market.

Yes. Nobody knows for sure what will happen but there is as strong a case for the bear scenario as for the bull. If you don't face that, a severe downturn may be more shocking than it should be to you and make it a lot harder to stay your course. Smart sailors don't head out to sea when there is a 50% chance of a hurricane intersecting their course. Courses should be set with a good awareness of all the possible conditions that a reasonable person knows could be faced.

I have some muni bonds, but seeing how far they dropped in March and how fast reminded me of how complacent we have all gotten. Funds with investment grade munis that usually moved only 1 cent a day now and then dropped 30 cents in a single day. That was enough to remind me why high yield bonds are not a suitable investment in turbulent times.
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ilan1h
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Re: Investing in lower quality munis or muni funds.

Post by ilan1h »

Scooter57 wrote: Sun Oct 18, 2020 8:12 am
I have some muni bonds, but seeing how far they dropped in March and how fast reminded me of how complacent we have all gotten. Funds with investment grade munis that usually moved only 1 cent a day now and then dropped 30 cents in a single day. That was enough to remind me why high yield bonds are not a suitable investment in turbulent times.
You seem very surprised by what happened to munis in March. I have a lot of munis in my portfolio and I remember the exact same thing happening in 2008. They plunged very rapidly as panic selling ensued and there was not enough liquidity to deal with the sell off. They recovered rapidly. My munis in 2008 did well even while my equity portfolio plunged 40%. I fully agree with your comments about irrational behavior in the equity markets and am also concerned that there appears to be a disconnect. The WSJ recently reported that due to the pandemic there were many new younger, less experienced traders (eg: Robinhood) that are contributing to the ebullience. There are also way more people trading penny stocks now than before. But this is not the case for the muni markets. Muni markets had increased inflows after the initial panic but these have recently tapered off. During periods of crisis munis tend to do well as investors flee to safety. Obviously it will be a long and slow recovery but I'm now aware of anyone predicting any kind of upcoming muni crisis.
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Re: Investing in lower quality munis or muni funds.

Post by UpperNwGuy »

ilan1h wrote: Sun Oct 18, 2020 9:54 am I'm now [not?} aware of anyone predicting any kind of upcoming muni crisis.
While I haven't heard predictions of an upcoming muni crisis, I am reading about cities and states having emptied their "rainy day funds" during the pandemic and hoping for another Federal stimulus bill to stabilize their finances. That tells me that states and cities have lots of budgetary problems in their future, and that should increase the risk of their bonds.
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Re: Investing in lower quality munis or muni funds.

Post by Scooter57 »

2008 did not pose the same threat to municipalities. People still flew, stadiums were filled, students paid dorm fees, people ate at restaurants, went downtown and parked, etc.

I think there is a big gap in perception between people who have lived in regions where the pandemic has already raged and those where it is getting started.

I also question the idea that the government can just keep pouring out money to fix everything. There is going to be a tough period ahead no mater what happens next. Lots of firings, lots of small business failings and lots of people who don't die but are left with persistent medical problems. I see it where I live.
JackoC
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Re: Investing in lower quality munis or muni funds.

Post by JackoC »

000 wrote: Sat Oct 17, 2020 5:32 pm I don't see why risk should only be taken on the stock side. I don't see a particular connection between the forward-looking risks of low quality munis and stocks. In fact, because the US index is so highly concentrated in a handful tech companies and a lot of state/municipal revenue comes from non-internet activities, they would seem to be somewhat uncorrelated sources of risk.

In what kind of world do stocks AND low quality munis fail? I'm guessing one where you need land, arms, and metals; not stocks or bonds.

Of course, I wouldn't expect low quality munis to retain liquidity during a liquidity event.
Nobody has absolutely has to limit risk assets to stocks. But I think some of the above discussion about the history of even investment bond index returns just suggests how complicated it actually is to analyze the value you are getting for the risk. It's pretty easy to get attracted by yield premiums one doesn't really understand. And for a retail dominated product like municipal bonds the idea 'well the market has priced it correctly so I needn't worry' is not as ironclad either.

Muni credit risk and the US stock market aren't entirely correlated but obviously related in two major ways. First general correlation to the US economy, and particularly in view of the current situation. If the economy doesn't recover/'reopen' as fast as expected, lots of muni revenue sources don't recover either. Beyond that, state and local govt pension fund investments in the stock market are a more direct connection between the two markets, a worrisome correlation IMO even for high grade muni's to some degree. For low rated muni's that correlation tends to rule them out from my POV as a stock heavy investor. I am willing to tolerate the risk of shorter term high grade muni's in my 'safe' allocation (supplemented by a larger allocation to CD's).
000
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Re: Investing in lower quality munis or muni funds.

Post by 000 »

JackoC wrote: Sun Oct 18, 2020 4:52 pm Muni credit risk and the US stock market aren't entirely correlated but obviously related in two major ways. First general correlation to the US economy, and particularly in view of the current situation. If the economy doesn't recover/'reopen' as fast as expected, lots of muni revenue sources don't recover either. Beyond that, state and local govt pension fund investments in the stock market are a more direct connection between the two markets, a worrisome correlation IMO even for high grade muni's to some degree.
Thank you for pointing this out.

As far as the economy not reopening, I don't think there is much connection between the US stock index and the IRL economy anymore.
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Re: Investing in lower quality munis or muni funds.

Post by BogleFan510 »

I'm not suggesting this now, because I have very limited current knowledge of this market.

However, to add a contrary view I will note that I have done very well with a mid sized portfolio of long term muni bonds (30 year) in my state with AA- to BBB+ ratings.

At the time I built this portfolio I had spent considerable time to educate myself on the subject and specifically researched some entities that had slipped ratings and why their credit scores had dropped. It was important to see what their future revenue streams looked like and what assets or entities backed them. I noticed at Schwab that their tool usually defaulted to A- and that sometimes listings of only 5k or 20k came up for a thinly traded BBB+ bond. The pricing was such that it seemed a firm was trying to dispose of an 'odd lot' asset and I would bid on these. They were typically selling at .75 to .85 of par. It took some patience.

Most performed amazingly well. Most were called at par before 30 years, so the imagined income stream lasted closer to 10 years (not suprising, given falling rates for decades, was rebuying at lower rates each round, and less discounts).

One issuer (PR sales tax) did default, but the combination of insurance or a negotiated settlement against assets backing the bonds eventually made me pretty much whole or well ahead (some insurers still paying on PR bonds at $1.10 to 1.20 par, if sold).

Its not an easy, set and forget type thing, but returns were there. I am not currently buying, except through fairly large bond funds I now hold instead, as bonds mature. In retrospect, the bonds were a good investment for my goal of creating a tax free revenue stream, but ended up being more like an investment in a preferred share. The upside was hard cap limited, even with everything going right (falling rates, recovered ratings to AA or better, or insurance paying on default), so not all that exciting. Kinda like buying a 'fixer' rental property without the management headache. I don't think the deals look so great anymore with everyone chasing yield. I imaging bond brokers can easily unload their 'junk' at higher prices these days, so dont discount much.
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