Owning Bonds in a Challenging Environment
In the last few months, a considerable amount of attention has been devoted in the financial press to the diminished prospects for bonds going forward. These concerns arise out of the combination of low current yields on bonds and the expected adverse impact on bonds from rising inflation and interest rates, which have been long-anticipated. Some of this focus has been sensationalized, such as a recent segment on “60 Minutes,” in which one analyst predicted a virtual implosion in the municipal bond market. Against this background, we want to provide our perspective and outlook for bonds.
Without question we have lower expectations for bonds going forward. In our view the thirty-year bull market in bonds has come to an end. The tailwinds provided by high initial yields and falling interest rates since the early 1980s are now gone, as rates have hit rock-bottom. Instead, bonds will likely face headwinds, in the form of low initial yields and the likelihood of rising interest rates.
Investors considering moving part or all of their bonds into stocks should bear in mind that they are trading one risk for another. In fact, equity risk is generally higher than bond risk, even though stocks may offer more upside potential at present. A bad year for bonds, like 1994 (a short-term rising interest rate environment), saw the Barclays Aggregate Bond Index drop about 3%, a far cry from what can happen in a bad year for stocks. While a change in an investor’s asset allocation may be appropriate, it should always be done with a full recognition of the risk and reward trade-offs.
Overall, we continue to believe that bonds have a sensible place in most client portfolios. While we have lower expectations for bonds in the near future, we remain convinced that most investors still need both stocks (for growth) and bonds (for stability and income) in their optimally balanced portfolios.
An additional word on municipal bonds. Financial conditions for states and local governments are materially worse than they were a few years ago, with large pension and health obligations looming over cities and states that now receive lower revenues than in the past. Nonetheless, interest payments to bond holders still represent a very small percentage of overall annual budgets, and maintain a high priority in getting paid. For example, the state of California is required constitutionally to pay debt service second only to education, before retiree payments, prisons, and government salaries.
Most municipalities also have the power to raise taxes (or rates) and cut services, providing higher revenues though at the direct expense of their citizens. We have already started to see hikes in taxes (e.g., Illinois’ sharp tax increases for both individuals and businesses). Overall, nearly half the states have raised personal, business, or sales taxes for the coming year.
While default risk does exist, we expect defaults to be rare and occur at the lowest end of the quality spectrum. Our muni bond managers concentrate on the highest quality bonds, especially revenue bonds like water and sewer bonds, which have a captive audience of ratepayers. Given this, we are confident in the creditworthiness of our municipal bond holdings. (We are concerned about recent talk in Congress about giving state governments an ability to declare bankruptcy, or to make muni bond income subject to federal taxes. These measures would be detrimental to the muni bond market. Though we think these moves would be reckless and even counterproductive, we know that they are not inconceivable and are watching them closely.)
It is also noteworthy that in the fourth quarter of 2010 municipal bonds were adversely impacted by two developments that have now been factored into the market: one is the extension of the federal income tax rates (making municipal bonds less attractive than had rates increased), and the other is oversupply of bonds (which depressed prices) in advance of the expiration of the Build America Bonds program.
While municipal bonds in the current environment do not appear to be as conservative as once believed, we think they still represent a sound choice for high-income investors. Notwithstanding the headline risk and legitimate concerns about municipal government finances, bondholders of higher quality muni issuers will continue to be paid.
