Recently there has been a lot of turmoil in the credit markets. A series of events occurred and there are implications on other financial instruments. This article focuses on the impact on municipal bonds issued by state and local governments which are exempt from Federal income taxes (mostly) and even state income taxes (once again, mostly).
From reading the article, you are able to find the following useful facts:
- The value or "price" of existing municipal bonds has declined. Thus a bond that was selling for 100 cents on the dollar (or "par") would be selling for less, maybe 98 cents on the dollar. If the price on a bond declines and the interest rate stays the same (which it does, since terms for it are set when the bond is issued), then the "yield" effectively goes up because a bond paying 5% gives you back more than 5% (maybe 5.25%) if you purchase it at a discount to par
- There has been a "flight to quality" overall as investors purchase US Treasuries (regarded as the safest investment) which reduces its yield and the inverse of this is that the yield has risen on other debt securities with less demand
- Some new municipal bond issues have interest rates > 5%, which is higher than rates have been recently. Not mentioned is the relative risk of these new issues, since you receive more interest in exchange for more risk
- Bonds with higher risk have seen their price decline (discount from par) meaning that their owners have suffered a loss. This loss would only be realized if they didn't plan to hold the debt until maturity, if you own the bond yourself. If you buy bonds in a mutual or closed end fund, however, the value of the fund declines immediate and these losses are reflected in the price - not really described in the article is that fact that purchasing bonds individually and holding them until maturity functions differently than purchasing them in a mutual fund
- "Callable" bonds have seen their price decline, and thus their yield rise, because investors don't want the "prepayment risk" that the issuer will call the bonds when interest rates are lower and give back the cash, thus forcing the former owner to re-invest those funds in a lower rate interest environment
- Individual bond prices are opaque and difficult to determine. The article references doing research and finding a "trustworthy broker" (as if it were that easy - do you look under "T" in the yellow pages?) to purchase the bond to ensure that you don't over or under pay
One very relevant fact is that states favor their own issues with tax breaks and this is under attack in the court system. The supreme court agreed to weigh in on this issue a few months ago but has not issued a ruling. This will impact the prices of bonds in many states that have high income tax rates like California and New York. To their credit this has been discussed elsewhere at the WSJ but not in this article and you'd have to know where to find it.
Another relevant fact is that the yield curve is basically flat or inverted which meant that long term rates weren't much higher than short term rates. The impact of this is complicated on long term borrowers like municipalities and I wouldn't even try to summarize this in a few sentences, but it is relevant to this discussion (point of fact).
I think that the most bizarre element of this article is that it basically is saying that there are opportunities today because the prices have declined, but doesn't really start with the fact that the vast majority of people who would be in a position to benefit from this decline (jump in and buy) are currently swallowing losses caused by this very event, because they likely have extensive debt portfolios.
Like any traditionally trained journalist, they have to have a human reference in the article somewhere, even if it is irrelevant. It ends with the fact that someone is buying callable bonds with a yield of 6%, even though they are almost immediately callable.
The problem is that the writer is taking a super-complicated topic which is the overall state of the muni bond market and attempting to summarize it in one disjointed, small article. A series of facts, mostly relevant, are thrown into the stew, and other facts are omitted. There is a mandatory human interaction element, even though it doesn't really add any value to the purpose of the article. I am struggling with how I would do a better job on this article, but the real answer is that I wouldn't even attempt to write this topic in a short article. I'd either assume that the audience was super-sophisticated and write it for them, specifically saying that I though callable bonds were an opportunity, or I'd write it for generalist investors and start with a description of relevant facts necessary to understand the article and then deliver a conclusion, likely in a much longer space.
If you are looking for my take on municipal bonds, I would be making the same mistake to try to cover it in a tiny space without a systematic structure or organization for the layman. If you are a professional, you probably have a better answer than me, anyways.
Cross posted at Chicago Boyz