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Individual investors love municipal bonds.
In fact, they directly own about 44 percent of the $3.69 trillion in munis outstanding. Mutual funds — often used as a proxy by individuals to indirectly invest in the market — own another 28 percent.
Conversations I’ve had with investors at conferences and elsewhere tell me the same thing. They want yield, and they think munis are a safe place to get some, especially with the tax exemption “kicker.”
That’s true historically. Munis very closely tracked Treasuries, with very little “risk premium” built in. But are munis as safe as bonds issued by Uncle Sam anymore?
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| S&P’s downgrade of Puerto Rican bonds to junk status puts added pressure on the muni market. |
That view sure is getting tested. First there was Detroit, which filed for bankruptcy last summer under the crushing burden of $18 billion in debt and other long-term liabilities. Many investors tried to shrug off the filing as a one-time event, something years in the making.
Then concerns flared about Puerto Rico, a much bigger player in the municipal bond market. The U.S. territory has $70 billion in muni bonds outstanding. Its bonds are sprinkled throughout 70 percent of the mutual funds that own munis, in part because they’re exempt from state and federal taxes.
Weak economic growth and elevated unemployment have put pressure on the Puerto Rican government’s finances. So have long-term pension obligations. As a result, Standard & Poor’s just cut the island’s rating to BB+ from BBB- this week, putting it in junk territory. That could reportedly exacerbate Puerto Rico’s cash crunch by forcing it to front an additional $1 billion in collateral and swaps payments.
The iShares National AMT-Free Muni Bond ETF (MUB) is my favorite benchmark ETF for tracking muni prices. It already lost a little more than 6 percent last year, and it took another hit in the wake of the S&P news. So did the Market Vectors High-Yield Municipal Index ETF (HYD), which invests in the higher-risk portion of the muni market.
I would be alert to the possibility of even more declines in the months ahead. In fact, I recommend paring your muni exposure dramatically. That is, if you didn’t already heed my advice to do so more than a year ago before the 2013 losses.
Here’s why:
First, I don’t like the outlook for bonds overall, with interest rates likely to rise once the recent correction runs its course.
Second, if you layer rising credit risk on top of rising interest rate risk, where does that leave you as a muni investor?
With losses, that’s where! If you need to invest in any part of the fixed-income market, stay in high-grade corporate debt and stay in very short-term maturities — less than two years.
Until next time,
Mike
Mike Larson graduated from Boston University with a B.S. degree in Journalism and a B.A. degree in English in 1998, and went to work for Bankrate.com. There, he learned the mortgage and interest rates markets inside and out. Mike then joined Weiss Research in 2001. He is the editor of Safe Money Report. He is often quoted by the Washington Post, Reuters, Dow Jones Newswires, Orlando Sentinel, Palm Beach Post and Sun-Sentinel, and he has appeared on CNN, Bloomberg Television and CNBC.
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PUERTO RICO HOBBLED BY THE JONES ACT AND CABOTAGE
One of the most significant contributors to the high cost of living in Puerto Rico is the Merchant Marine Act of 1920, also known as the Jones Act, which prevents foreign-flagged ships from carrying cargo between two American ports, a practice known as cabotage.
Because of the Jones Act, foreign ships inbound with goods from Central and South America, Western Europe, and Africa cannot stop in Puerto Rico, offload Puerto Rico-bound goods, load mainland-bound Puerto Rico-manufactured goods, and continue to U.S. ports. Instead, they must proceed directly to U.S. ports, where distributors break bulk and send Puerto Rico-bound manufactured goods to Puerto Rico across the ocean by U.S.-flagged ships.[ac]
Puerto Rican consumers ultimately bear the expense of transporting goods again across the Atlantic and Caribbean Sea on U.S.-flagged ships subject to the extremely high operating costs imposed by the Jones Act.[ad] "Under the protection of federal statutes, a monopsony has been siphoning scarce resources from the poorest U.S. jurisdiction to sustain a segment of U.S. industry that has become uncompetitive due precisely to the protection it has enjoyed."[167] "Although the Commonwealth of Puerto Rico and the United States should be considered the senior partners in a common market, the Cabotage laws, in practical terms, constitute a protective barrier that favors Mexican and Canadian ports of origin and destination against producers in Puerto Rico."[168]
The local government of Puerto Rico has requested several times to the U.S. Congress to exclude Puerto Rico from the Jones Act restrictions without success. The most recent measure has been taken by the 17th Legislative Assembly of Puerto Rico through R. Conc. del S. These measures have always received support from all the major local political parties.
In 2013 the Government Accountability Office published a report which concluded that "repealing or amending the Jones Act cabotage law might cut Puerto Rico shipping costs" and that "shippers believed that opening the trade to non-U.S.-flag competition could lower costs. The report, however, concluded that the effects of modifying the application of the Jones Act for Puerto Rico are highly uncertain for both Puerto Rico and the United States, particularly for the U.S. shipping industry and the military preparedness of the United States.
The result of this selfish regulation that protects the oil and transportation services is a gross economic inefficiency that reduces Puerto Rican enterprise and consumers ability to prosper!