Earlier today I cut positions in high yield muni bonds in half. Why am I selling muni bonds when everyone else seems to be buying them? Well, that’s part of the answer. Since president Obama won reelection, there’s been a flood of new money coming into municipal bonds (all types of muni’s), pushing them from slightly over-valued to very over-valued. But it’s high yields in particular that are starting to worry me.
In November 2010, analyst Meredith Whitney appeared on 60 minutes and made a bold prediction that we were about to see thousands of municipal bond defaults. Muni bonds cratered on the news. It turned out she was wrong, so far, which made the sell-off a great time to pick up muni bonds at discount prices. Since then, high yield muni bonds have generated returns to tune of approximately 11% in 2011 and another 15% year-to-date! At a 5% yield, that means an additional 10% return from the appreciation of the price of the bond this year alone.
I think it’s time to take some of those gains off the table. For starters, the bonds cannot continue to climb at this rate without either an upgrade in credit ratings or a big decline in interest rates, both of which I find highly unlikely. Second, history tells us that performance the year after a 10%+ return in the preceding year is not very strong. Not to mention two 10%+ years in a row. Lastly, too much money has been coming into these bonds after the news. The time to buy was a year ago. With the devastation from Superstorm Sandy estimated at over $50 billion, I would not be surprised to hear that some high yield related municipal bond projects in the Northeast will be having trouble servicing their debt payments… that’s the type of event that could trigger the next 8 – 10% sell-off.
High Yield bonds tend to be much more volatile than high quality, investment grade bonds. And with a duration on the Index around 10 years, I think it’s best to reduce exposure and wait for the next big dip to buy them back. (For the sake of keeping this post as short as possible, I won’t go into the details of duration. I’ll just say that it’s twice as high as I would like it to be)
I’m happy to take the gains and wait.
Nick
MarketVectors High Yield Muni Bond Index (HYD) – 4 years
