Every so often markets experience extreme reactions to situations that, in retrospect, turn out to be not nearly as extreme as anticipated. Near the end of 2000, prices of technology stocks soared to absurd levels and then crashed… crashed when the magnitude of economic growth from the internet was not nearly as extreme as anticipated.
Real estate from 2004 – 2008 appreciated in value like never before. Some investors were purchasing houses with no intention of living in them… just selling the houses to other investors in a few months at a higher price. Other “investors” were purchasing houses to live in but with no intention of ever making a house payment… why bother making a payment when you can sell the house in a few months at a higher price?
Every now and then the opposite happens. Occasionally investments get extremely cheap. This usually happens because of widespread fear and panic. Sometimes the fear is reasonable and “cheap” may be justified. Sometimes not.
Fear and panic are often functions of the unknown and the unquantifiable. We aren’t sure why we are afraid or how much we should be afraid and, until we find out, we err on the side of caution.
The municipal debt market in the U.S. may be in that category today. Investors are positive that some states, cities and counties will default on their debt. Because investors are not sure which municipalities or how many municipalities will default, prices of municipal bonds have taken a beating… and yields on many municipal bonds are at unusually high relative levels.
Never in my career (almost 30 years) do I remember a time when the interest rate on municipal bonds was higher than U.S. Treasury bonds. Municipal bonds, which are considered the absolute safest and rated AAA or AA by both rating services, have ALWAYS had a lower interest rate than U.S. Treasury bonds. Why? Because they are exempt from federal income tax… U.S. Treasury bonds are not tax-exempt.
For example, if you earn 5% on a U.S. Treasury bond and are in the 30% tax bracket, after you pay tax on your interest, you are left with a return of 3.5%. A municipal bond that is perceived to be almost as safe as a Treasury bond would yield a little more than 3.5%. Because you don’t owe federal taxes on the municipal bond interest but take some risk (since they are not guaranteed by the Treasury), your net interest will typically be just a little higher than the “after-tax return” of the Treasury bond.
Below is a graph of interest rates for bonds from 0 – 30 years. The graph is from 1993 but it is typical of virtually any year in my career (except this year). The red line represents the interest you would receive from an investment in U.S. Treasury bonds. The white line is the interest on AA rated General Obligation (GO-AA) municipal bonds.
You can see the 10-year Treasury bond has an interest rate of about 5.8% and the 10-year municipal bond is a little over 4.5%. That’s the way it should be because Treasury bonds are taxable and municipal bonds are tax-exempt.
But that is not the way it is today. The graph below illustrates the relationship between Treasury bonds and municipal bonds today. It’s upside down.
If you invest in a 10-year General Obligation municipal bond rate AA, you can expect to earn almost 4% per year TAX-FREE. A 10-year Treasury bond is paying around 3 ½% before taxes and well under 3% after-tax for most investors.
No doubt there will be more municipal defaults than history would predict. There are significant budget problems in California, New Jersey and Illinois. Expenses are being slashed and taxes are being raised almost everywhere in the U.S. This will likely be the worst fiscal storm municipalities have faced in a long, long time. That being said, we think the cheap price and high interest rates are not warranted in every municipality and careful research can unearth some unusual investment opportunities.
If we are wrong and municipal bonds experience massive defaults throughout the country…. well, we think you probably won’t want to have your money in the stock market either.
In my October Investment Commentary, I wrote that the worst may be behind us and that we might see monthly home foreclosures fall under 300,000 before the year is over. After 20 consecutive months of new home foreclosures in excess of 300,000, November fell off a cliff, coming in at 262,339. Okay, maybe the economy is getting better… but it is not getting THAT much better THAT quickly. The significant drop-off in new foreclosure filings is more likely a result of banks and mortgage companies running into roadblocks due to their own shoddy paperwork. They have all been required to stop, back up and start dotting their i’s and crossing their t’s. This is only a delay in the “flushing out” of the rest of the homes that will eventually go through the foreclosure process. Look for this number to pop back up above 300,000 a couple more times before this is all over.
The stock market finished 2010 with a nice December. The S&P 500 increased 6.68% which gave it a 15.08% increase for the year. The EAFE Index (Europe, Australia and the Far East) increased 8.4% in December which basically accounted for its return for the entire year.
Holiday spending was much better than expected. My take on that is that the American consumer has been deleveraging for the past couple of years and finally decided to let loose for Christmas. Look for some disappointing months in consumer spending this year as Americans realize deleveraging still has some work to do.
We hope the worst is behind us and that the economy continues to improve, even if slowly. Reasons to remain concerned:
- Housing prices probably have not hit bottom. “Shadow” inventory (homes that are not yet for sale but will be as foreclosures are processed) is difficult to ascertain or even prove. I find it difficult to believe that banks and mortgage companies are even close to getting to the bottom of the piles of papers on their desks… piles representing homes yet to be foreclosed upon.
- Europe is still a wild card. The European banks can bail out Greece, Ireland and Portugal. Spain, however, represents a more daunting problem. Spain’s economy is larger than the other three combined and a bailout of Spain is probably not realistic.
- Unemployment is still almost 10% and 42% of the unemployed have been out of work for over 27 weeks, more than twice as many in any previous recession. Although the recent recession was officially declared “over” in the summer of 2009, it continues to be an “unemployment recession.”
- Oil is surreptitiously rising and consumers are beginning to notice it at the pump. After peaking near $150/bbl three years ago (see graph below) and then plummeting below $40/bbl, oil has been creeping back up and is now trading around $90/bbl. The national average for gasoline is over $3 again. If this trend continues, it will put a dent in consumer spending.
Although our equity positions have increased over the past year, we remain keenly aware that stocks have enjoyed a generous rally recently and our eyes are focused on risk, not return. In addition, we are researching municipal debt as we feel today’s anxious climate is providing some good investment opportunities.
~Richard W. Boyer, CFP, CFA
Chief Investment Officer
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.