Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one [i]
— Charles Mackay
It can be said that relative portfolio outperformance – and the overall security of principal – is in many ways dependent on the avoidance of investing or divesting with the herd. Mackay’s words from his famous work Extraordinary Popular Delusions and the Madness of Crowds serve as an important lesson to avoid irrational herd-like moves. As we have learned over the last decade, only hindsight is 20/20 when it comes to pinpointing irrational valuations. The avoidance of herd-like situations is precisely why separately managed municipal bond portfolios offer an advantage to bond mutual funds or ETFs.
Separately managed account control
A separately managed bond account allows for greater control and is less subject to the fears of other investors in terms of mass redemptions. In the rising rate, headline risk environment we are experiencing today, this is a vital defense mechanism of a separately managed portfolio. The ability to select and also remove individual bonds from your account gives you the advantage of choice. Consequently, you neither need to invest nor sell with the herd.
According to the Investment Company Institute[ii] we have experienced 13 straight weeks of outflows from municipal bond mutual funds, amounting to a total of $35.3 billion. Total bond fund outflows (taxable and tax-exempt) over this period have amounted to just over $98.4 billion. The move in interest rates have corroborated fund flows over this time period, as the 10-year Treasury has jumped to 2.76% from 2.11% while the MMA 10-year “AAA” municipal index has increased to 3.07% from 2.22%.[iii]
Mitigating the consequences of fund outflows
The last time such a significant outflow from municipal bond funds occurred was at the end of 2010, when Meredith Whitney called attention to the strained fiscal situations and sometimes inadequate disclosures within the municipal market. From December 2010 until April of the next year, municipal fund outflows totaled $35.4 billion. The bond market was able to reverse this sell-off weeks later once investors realized the overblown nature of her prediction, but by then, the damage had been done.All bond investors – no matter what investment strategy they use – experience paper losses in their bond portfolios when the above mentioned sizeable fund outflows occur. When selling supply significantly outweighs demand, bond prices become depressed and bond yields often rise substantially. This is an immutable law of bond finance, if you will.
However, owning individual bonds in a separate account enables flexibility to both avoid and mitigate certain aspects of this market paradigm. For one, usually bond funds do not have a maturity date and there is no guarantee they will return to their original value. Barring default, individual bonds return principal at maturity, and as their maturity date approaches, their intrinsic value naturally moves to a par ($100) price. Additionally, individual investors within bond funds are not able to customize their tax-loss harvesting by offsetting capital gains with losses taken on specific bonds.
The cost of big bond fund redemptions
Most mutual funds maintain a small cash cushion in order to mitigate the pricing impact from routine liquidation levels from investors. They do not maintain a cushion to satisfy massive redemptions as they have experienced in recent weeks. Therefore, they must sell a portion of fund holdings in order to raise cash to meet redemptions. This is putting additional pressure on an already tense market; as noted, the footing of the municipal market is weaker today than it was in late 2010 due to a more volatile backdrop of escalating rates paired with headline risk arising from the Detroit bankruptcy petition and other stressed municipal credits.
As an example, the iShares MUB, the largest ETF that tracks the municipal market, currently sells for LESS than its component holdings – individual municipal bonds – due to the selling pressure of individual investors. The ETF currently trades at a 0.96% discount to its net asset value (NAV) versus a 0.31% average premium since 2007.[iv] Basically investors are trading this ETF at a value less than where the individual component bonds are priced. Thus, if an investor needed to liquidate a portion of their position in MUB, they would be hit with an immediate 0.96% discount, thanks to the herd’s move. In late June, this discount was as large as 2.85% – larger than many of today’s coupon payment rates.
This pricing anomaly probably will reverse itself at some point in the future. Time will tell. In the meantime, it should serve as a good lesson as one of the perils of investing with the municipal bond herd.
As always, please call us if you would like to review your municipal bond portfolio or if you have any questions.
Scott R. Rausch, CFA
Bernardi Securities, Inc.
August 28, 2013
[i] MacKay, Charles (1980). Extraordinary Popular Delusions and the Madness of Crowds (with a foreword by Andrew Tobias, 1841). New York: Harmony Books
[ii]http://www.ici.org/research/stats/flows. The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs) and unit investment trusts (UITs). Members of ICI manage total assets of $15.3 trillion and serve more than 90 million shareholders
[iii] Source: Bloomberg
[iv] Source: Bloomberg