Muni bonds used to be the boring, predictable part of your investment portfolio. Not anymore.
In January 2011, Greek—I mean, Illinois—politicians had a problem. They had over $6 billion in unpaid bills sitting on their desks. Their best solution? Pass a 67% income tax increase. Fast forward a year, and Illinois clearly did a great job of increasing income tax collections. They did such a good job that their revenues jumped 31.9% in 2011, the second-highest increase in the nation! Problem solved, right? Not exactly. Now Illinois has $9 billion in unpaid bills.
What's that got to do with you? If you're a successful business owner and you are accumulating taxable savings, odds are you are helping to finance these mismanaged budgets through a healthy allocation in municipal bonds. Historically this has been a slam dunk as they have paid a higher after-tax return than taxable bonds, assuming you are in a high tax bracket.
Well, in the world we live in today, are munis still the right answer? I'm not so sure they are. Recently I was working with a very large bond manager looking at an analysis of how they would allocate a multi-million dollar taxable bond portfolio. Their answer was to put zero in munis. You read that correct, ZERO. In my whole career, I have never seen anything like this.
Part of the logic rests on the current yield environment and the outlook for returns going forward. The after-tax returns on high quality munis are less than the after-tax returns on other portions of the bond market like mortgage-backed securities, foreign/emerging markets, high yield, and some high quality corporate bonds. In addition, the muni market continues to shrink in size relative to the growth of the global bond markets. In fact, U.S. municipal bonds represent just 3% of the global bond market. The big kicker is with confidence. Some states force you to look and ask yourself, "Why take the risk?" Illinois, the current poster child of mismanagement, now has the lowest credit rating of all 50 states.
For many investors the bond portion of the portfolio is supposed to be boring—calm, predictable, reliable. Fed Chairman Bernanke has been bending over backwards to keep it that way, exemplified by the continued zero interest rate policy. But, as many bond professionals are pointing out, storm clouds are on the horizon.
Inflation, although not a large threat today, looms. Looking ahead, there will be a need to print money and devalue our currency to help us escape our own debt. Inflation hasn't picked up yet, not because we aren't doing our best to print money, but because the velocity of money is so low. When this starts to return to normal levels, inflationary pressures will mount causing a headwind for bonds. Finally the biggest concern for some is the Fed's need to ultimately unwind their "Quantitative Easing" programs of the last several years. As these programs are reversed, what will the impact be on bonds?
Many feel the return on all bonds is going to be challenged going forward; however, munis have been viewed with an even more critical eye. States have been the benefactors of low borrowing costs, but low yields and deteriorating state finances have changed the calculus for taxable investors. If this causes taxable investors to start viewing munis as a much less attractive holding in their portfolios, this could impact demand, and thus prices. The Greeks know all too well how this plays out.
Nearly all politicians are incapable of making hard choices. Instead, the tough choices have to be imposed from the outside. In the case of Greece it was the IMF, the ECB, Germany, etc. In the case of munis, it very well may be the individual investor deciding their money is best invested elsewhere.
Chad Carlson, CFP, CFA contributed to this article.
MARK BALASA, CPA, CFP is Co-Chief Executive Officer and Chief Investment Officer of Balasa Dinverno Foltz LLC. Mark has been named seven times as one of the “Best Financial Advisors” in the U.S. by Robb Report Worth magazine.