We may have entered a point in time where the prevailing wisdom is no longer “I have muni bonds, therefore I can’t lose any money.”
For many years, investors who wanted to either protect their money, or were looking for a way to minimize taxes, would begin to purchase munis, bonds that can be both federal tax exempt and even state tax exempt depending which bonds you purchase and where you live.
However, now more than ever, investors must pay attention to the bonds they own and what is happening in the fixed income market. If you haven’t heard, there have been some municipalities bailed out by their parent states like in Pennsylvania. Another example is California. They have been in the news for well over a year as being insolvent and in need of either drastic spending cuts or a federal bailout, or both. Those investors that hold bonds in California are risking the return of their principal if their bonds have been issued by certain municipalities or counties. The thought that the entire state may default is not a welcome one, we’ll see.
When looking to buy bonds, muni buyers also tend to be corporate bond buyers for their retirement or IRA accounts. Since interest rates have remained extremely low, those same investors have been on the hunt for anything that can increase their income, sometimes at the expense of credit, quality or both. Unfortunately, many people have been purchasing high yield mutual funds and high yield bond funds. While many of the investment advisors, mutual funds and brokerage firms have been touting these as a great way to diversify and increase your income, please be aware of the risks involved:
- Bond fund do not have a stated maturity, therefore there is no date specifying when you get a return of principal, and if the fund if down in value more than the stated interest, you may lose part of that investment.
- Interest rates are at a historic low. Into the future, they will rise and when this happens, the value of the bonds within these funds will most likely drop in value, negatively affecting the value of the fund. Again, you could lose principal value.
- High yield bond funds typically get the higher yield by investing in less than pristine corporate balance sheets. Translation – lower credit quality companies, lower quality companies and higher risk!
- High yield funds, in some cases especially when looking at “closed end” mutual funds, utilize leverage when investing in bonds. Simply put – they borrow money against the bonds they hold to buy more bonds. When interest rates rise, or bond prices fall, the investor typically suffers more than non leveraged funds. (Who thinks borrowing money against risky investments to buy more risky investments is a good idea?)
In summary, be careful in today’s environment when investing your money in muni bonds, corporate bond funds, lower grade bonds in general and any other investment that is subject to credit and interest rate risk.
Invest deliberately and with common sense.