A Change in Municipal Bond Ratings

This article previously appeared as a new feature at Target2025.com: Repercussion- A Retirement Review.

We are far from free of the clutches of the Great Recession.  The hold that the recent economic downturn has had on numerous types of investment portfolios will continue, even if, one the surface, it seems to abated somewhat in the equities markets.  The recent decision by Fitch, a bond ratings company, to revisit their grading strategies of municipal bonds may be simply cloaking the possible maturity wall facing bond investors.

Municipal bonds have historically been rated slightly lower when compared to corporate bond issues.  While the default rate for munis is much lower (0.7% compared to 2.1% default by corporate bonds) these debt securities used for public financing of roads, water, sewer and other public projects have often received a slightly lower rating.  This despite what appears to be a robust fiscal balance which includes increasing tax revenue, the ability to enforce revenue collection, control over expenses gives the municipality better flexibility, and the right of local communities  to tap reserves when needed.

The question is simple: will this change in ratings by Fitch (following a recent change initiated by Moodys), often moving munis up a grading notch provide better transparency or simply complicate the ability for buyers of these bonds to tell the difference?  This is of particular concern for those close to retirement looking to exert more stable control over their accumulated assets, fixing their projected returns and protecting capital.

It is our belief that munis will be approaching the same "bubble status" as mortgage backed securities attained just two years ago.  While Fitch claims to be looking at the long-term ("The aspiration is for Fitch’s ratings to demonstrate broadly comparable levels of default patterns over long periods") they may be looking at more historical data on the sector rather than the possibilities that in the near future, these securities might be facing the same trouble as the rest of the bond market might face in the coming years.

The "Maturity Wall", a point in the future when a great deal of corporate and Treasury bond issues mature and demand for debt might be overwhelmed by too many choices, often at higher prices and lower yields. Seeing that possibility will force investors to flock to munis if they feel as though they are immune.  They may well be in just as much trouble if the projects they are undertaking fall short of funding from the federal government.

More from Dan Seymour writing in BondBuyer

Retirement Planning: Close but Not Quite Close Enough

More folks are looking at the past year with notable regret. They are looking at the fate of their investment strategy and wishing they had listened to the few who were warning of the coming investment storm or, promising to change their thinking in favor of a once-bitten-twice-shy approach moving forward.

Those closer to retirement are concerned that their current portfolio balance may not be enough to get them to retirement or, they feel comfortable with the current balance and want to protect whats left just in case. To those who have suffered losses, moving the whole of what you previously owned can be fraught with perils.

Your old portfolio was probably more open to risk and was not forward looking as much as it was now looking. You would check your portfolio and congratulate yourself for your investment savvy, even if the gains were due to market forces you knew little about as long as they trickled into your portfolio. But now we realize that this was not a very prudent approach. And as human nature dictates, we recoil from doing the same harmful thing again. (Although that same human nature is also responsible for our short-term memory, a hindsight look at risk that argues it was probably worth it; I'll try again.)

Leaving well-enough alone, even if it is not as well as you would have liked it to be, is actually the most prudent method for recovering those losses. Selling at the bottom, especially in a mutual fund, does not allow you the time to recoup and, if you you still have a long-term approach, shuns the idea that any recovery will take place. (In a previous post, I suggested that this could take as little as four to six years.)

But what do you do to change the habit of chasing market fads? First, leave the funds you currently own right where they are. This doesn't mean that you should ignore them completely. What it does suggest is no longer funding them if you are within five years of retirement.

Instead, use new money to take a new approach. Fixed income has become much more attractive post-meltdown and for good reason. There are some guarantees that your money will still be there when you retire. Building on your stock allocation with bond funds is not only wise, it has been highly suggested by many planners. (What those planners will also suggest is moving from one fund to another. Not wise.)

Municipal bond funds have become increasingly attractive. The reason I suggest buying munis through a bond fund is the relative inability of the average investor at determining the risk in these bonds. (Yes, there is risk. Some municipalities may be facing dire straights as a result of the current economy and will offer too high a return to attract investors.) But right now, munis have a sizable spread over Treasury offerings of similar duration meaning that, to attract investors, the yield is higher over the same period of time.

To fully appreciate what a bond can do for your portfolio, but a total bond fund that encompasses a broad swath of fixed income debt. Because there is risk and fees, don't think you can simply buy in and forget about it.

Inflation could create problems in the future diminishing the expected returns and making your invested dollar worth less even as the face value of it remains the same. Interest rates could fall as well and investors who purchase bonds outside of a bond fund are more vulnerable - provided they are aware of these two key elements: If you hold a security until maturity, interest rate risk is not a factor. You’ll get back the entire principal upon maturity. But if you buy a bond that is considered a zero-coupon investment, you might face some interest rate concerns. Zero-coupon bonds make all their interest payments when the bond matures and because of that, they are the most vulnerable to interest rate swings.

Credit agencies rate bonds based on numerous factors. The higher the rating, the lesser the chance you will face a default risk. In other words, the higher the rating on the bond, the greater the likelihood you will get your principal back in tact. But on the flip side, the yield for this degree of safety is much lower than on a riskier bond.

Another good reason for using a bond fund is liquidity. Suppose you had one to sell and no one wanted it? And the last big risk factor is reinvestment. A bond you may be holding may be called back, a move that essentially allows the issuer to pay off the bond, return your principal and leave you looking for a similar bond with comparable yield.

Even those these risks persist, a bond fund helps alleviate them. I'm not so sure a Target-dated fund could do as well. In my mind, it would be like fighting a war on two fronts.