In BSW Blog, BSW Philosophy, Economic Outlook

As discussed in the December 23rd BSW Blog post, it is quite probable that there will be some cities and, potentially, states that fail to make payment(s) to certain bond holders.  The drama currently unfolding in the state of Illinois (see article here) offers a preview of coming attractions in other fiscally mismanaged municipalities.  Illinois is facing a $13 billion budget deficit and, in response, is considering raising the state income tax by 75 percent, from 3 percent to 5.25 percent.  As more municipalities hit the proverbial financial wall, the headlines will likely prompt a general sell-off in the municipal bond market as hyper-reactive, “buy-high, sell-low” investors rush for the asset class exits.  But what might this mean for YOUR municipal bond portfolio?

First, it is essential to remember that BSW primarily invests in individually laddered bonds that we intend to hold to maturity.  As such, the day-to-day pricing fluctuations of individual bond positions are largely just market noise.  As discussed in our December 23rd blog post, BSW’s bond buying methodology aims to identify and purchase the highest quality bonds with a focus on yield-to-maturity at cost.  Once the bond is purchased, the yield-to-maturity at cost is fixed.  Further, if the bond is held to maturity, it will be redeemed at par value.  The bottom line is that the value of YOUR bonds (as reported on your custodian’s statements) will go up and down in response to market and investor sentiment, which is likely to be volatile during the next 12 months.  Those fluctuations, however, are largely irrelevant because your bonds are intended to be held to maturity, your yield-to-maturity at cost is fixed, and we expect maturing bonds to be redeemed at par.

Second, if there is a general sell-off in the municipal bond market, it could present an outstanding buying opportunity.  Remember that in the bond universe, price and yield move inversely to one another.  As a bond’s price falls, its yield (at cost) increases.  Just as the equity market sell-off of 2007 and 2008 created an outstanding stock buying opportunity, prospective turbulence in the municipal bond market could provide astute and willing investors with superior yields on outstanding bonds from fiscally-health municipalities.

Finally, as mentioned in the December 23rd blog post, it is important to keep in mind that all bonds are NOT created equal.  Although the movement of the broader municipal bond market is an important economic and market indicator, defaults or missed coupon payments on low-quality municipal bonds (such as shaky revenue-backed bonds) will not impair the viability of higher-quality municipal bonds (such as general-obligation debt of proactive cities, counties, and states with healthy balance sheets).   Investors in high-quality municipal bonds should steel themselves to confidently ride out any potential storms or crises of confidence.

If you have any additional questions about your municipal bond holdings or investment portfolio, please contact BSW.  As always, we are happy to help.

-David Wolf, Chief Investment Officer

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