Investment Journal

Municipal Bonds… and Illinois

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Illinois Bond Sale

MUNICIPAL BONDS

A difficulty with finance is that statistics are all backwards-looking. For instance, there were umpteen articles about how stocks “return x% over y number of years” or that “residential real estate is a solid investment based on returns in area x over y number of years”. We all know how those assumptions turned out.

While research is useful and assumptions need to be made, a crucial error that has lead to much of our financial malaise is due to retaining assumptions too long rather than chucking them aside when the underlying facts on the ground change. You also need to be aware of shifts in sentiment and try to anticipate what is going to happen next.

Specifically, municipal bonds have historically had a low default rate, less than 1%. And when they do default, investors generally have a relatively high “recovery percentage” (as opposed to Lehman when creditors received 7 cents on every dollar owed). Many investors view them as almost as safe as the debt of the Federal government. Municipal bonds are (generally) tax-free, so a municipal bond can have a lower debt coupon and still attract as many investors as a tax-adjusted amount from a corporate bond sale. I am generally speaking of general obligation debt, not the revenue bonds that might be tied to corporations or other initiatives (these carry a higher coupon and default rate).

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iBonds Update

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Here is an article about iBonds, which are inflation-protected securities that you can buy from the US Government online that are fully guaranteed. iBonds right now are yielding over 5% because of higher inflation; this could always change in the future. Read more if you are interested.

Recently I have been writing about investing in secure securities (i.e. where you can’t lose money, except in extremely unlikely scenarios). I focused on purchasing CD’s that are insured by the FDIC and constructing a “ladder” of varying maturities through your brokerage account. The return on these CD’s is much higher than is currently being offered by US Treasury securities and has other advantages such as convenience and simplification of statements.

There is another form of safe investing that is easy to do and risk-free (assuming the US Government does not collapse). This is called an “I Savings Bond” or “iBond”.

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Treasuries vs. Certificates of Deposit

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Here is a brief article about purchasing CD’s through a brokerage vs. recent rates on Treasury securities.   Read more if you are interested.

PURCHASING CD’S THROUGH YOUR BROKERAGE ACCOUNT

Recently I wrote a post about how CD’s can be purchased through your brokerage account (Fidelity, Schwab, Vanguard, etc…) and how easy that it is to do so.

Recently I built a “ladder” by taking the amount that I wanted to invest and breaking it into 4 equal groups and buying CD’s as follows:

one year interest rate 2.75%
two year interest rate 3.95%
three year interest rate 3.9%
four year interest rate 4.1%

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Default Rates and Static Analysis

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As recently as a early 2007 ago there was very little “risk premium” between debt of varying quality. The risk premium is usually measured against US Government debt (Treasuries) of equivalent duration (i.e. a 5 year bond compared to a 5 year security). For instance, if the Treasuries were yielding 5%, then high-quality (at the time) corporate debt might be issued at 6%, with riskier debt as high as 9% (a premium of 4%).

At the time I wrote that this absence of a risk premium was unusual and meant that buyers of debt were being paid very little (beyond what they’d get for a risk-free government issue) for taking on the business risk tied to these often highly leveraged, cyclical businesses. As it would later turn out, these yields were far too low, and since have widened to historically high levels. For example, while Treasuries are around 5% now, “junk” bond yields for new issues are near 20%, which is an amazing premium of 15% or so.

Some analysts are saying that these yields are TOO high (i.e. the market is demanding too much for the level of risk that you are taking on). By their reckoning, companies would have to default at a rate that they didn’t even approach during the great depression in order to justify these yield levels. Others are recommending that this might be a good time to jump in at these levels.

While their calculations of required failures do indeed seem high, the analysts have failed to take one CRITICAL variable into account – the absence of liquidity – essentially they are only modeling the risk of default in isolation.

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Certificates of Deposit (CDs) In Your Brokerage Account

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There have been some recent changes on FDIC insurance limits for CDs and there is a (relatively) new way for time strapped investors looking to buy CDs, which is through a brokerage account. This method allows investors to pick from a variety of institutions online at a single place and receive the income in their brokerage account rather than physically go from place to place to purchase CDs and then receive a pile of paper at year end. There also is the ability to sell CDs in the market during the life of the CD (i.e., you could sell a 5 year CD 2 years into it) at either a gain or loss depending on the direction that interest rates have moved in the interim (down, you will have a gain, and up you will have a loss). You can keep it until maturity and always get what is promised, this is just another subtle opportunity. Read more if this topic interests you.

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