Bond Holders Have to Size Up Risk
Harold Camping may be a name you now know. He is in the prediction business and he’s been wrong twice now on “the beginning of the end of time.”
Some of his followers sold all their possessions, quit their jobs and drove to California to await his prediction of the Rapture on May 21. They essentially bought into his calculations and made risky decisions that they likely are regretting a week later. In 2010, prominent industry analysts warned of a looming fiscal crisis among state and local governments. Some experts even predicted widespread municipal bond defaults across the United States. Investor fears intensified in late 2010 when the municipal bond market experienced one of its largest sell-offs in decades, which drove up bond yields.
So, is the municipal bond market at risk for widespread default? No one knows – and we are not in the prediction business. But your view probably depends on your economic expectations and familiarity with the municipal bond market. Managing the prediction of risk is a tricky business. Investors always should consider ways to manage it in their fixed income portfolios. Here are a few guiding principles:
– Hold shorter-term issues. This approach may help reduce volatility while enhancing liquidity. Also, fixed income investors who hold investment grade bonds must consider their exposure to changes in interest rates. Bond prices move in the opposite direction of interest rate changes – and the longer a bond’s maturity, the greater its price change.
– Stay broadly diversified. Holding many municipal bond issues and avoiding concentration in a particular state, sector, or issue type can help reduce the impact of a few nonperforming bonds. If default rates rise, investors with a well-diversified municipal portfolio should be less exposed.
– Focus on quality and use market pricing to confirm credit ratings. The most creditworthy bonds are those rated AAA or AA, and most of the current problems involve lower-rated bonds. Although ratings are useful, recent history in the mortgage backed securities market has shown that a bond may not be rated accurately. A bond that is rated AAA should trade in a similar price range to other bonds with similar characteristics and a comparable rating.
Investors can either hold a portfolio of individual municipal bonds or buy shares in a fund. Building a portfolio of individual bonds offers more direct control over maturity,
face value, bond type, credit range, and other issue characteristics. This approach may be useful for matching future liabilities and pursuing other investment objectives.
But achieving broad diversification with a custom portfolio may prove a challenge, and the portfolio may be less liquid and expensive to trade and require more attention and
oversight than is feasible for an individual.
Camping’s followers would have been better off to remember Matthew 24:36, which says “No one knows the day or hour when these things will happen.” The same holds
true for the predictions of widespread default in the bond markets. Extreme action in the face of speculation can lead to poor decisions that ultimately leave you looking
back with regret.