‘Things are seldom what they seem…

…skim milk masquerades as cream’

When investing in tradable securities, we sit across the table from the financial alchemists of Wall Street and the City of London. Unlike shares in companies, bonds are mostly bought and sold over the counter (OTC) and are not subject to the same scrutiny as the common or preferred stock of a company that’s listed and trading on a registered stock exchange.

This reduced scrutiny is particularly true of the high yield and municipal bond market in the US and the local government tax exempt bond market in the UK. For all but the sophisticated investor, a veritable witch’s brew of non-aligned interests puts the odds of success firmly in favour of the issuer of a debt obligation (debtor) at the expense of the purchaser of the bond (creditor).

Municipal bonds are sold to investors as a low-risk investment, paying interest while promising a tax exemption on interest payments and protection of capital. Asymmetric access to information in favour of Wall Street and the City of London is one of the most significant problems in the tax exempt bond arena.

In 1975, an act of Congress led to the regulation of insurance and trading of municipal bonds in the US, but examination of who sits on the Municipal Securities Rulemaking Board shows that they are predominantly employees of banks and brokerage firms: the foxes guarding the chicken coop!

When issuers of municipal bonds default, as happened in Detroit in July 2013, investors lose all of their capital. Investors who do not possess a sophisticated knowledge of the market should approach municipal bonds with caution.

The credit market is now more highly leveraged (investing borrowed money) than at any time during the financial crisis of 2008-9. Some 45% of investment grade bonds now stand one notch above junk, meaning bonds with a high probability of default.

Municipal bonds and other tax exempt securities offer a powerful attraction by avoiding interest income from federal and in some cases state taxes. However, this comes at the price of political risk (will tax rates change?), credit risk (will the issuer default?), call optionality (the issuer wins when interest rates fall at the expense of the bondholder) and trading costs (an opaque regime benefiting Wall Street and the City at the expense of retail investors).

Call optionality and opaque trading mechanisms diminish expected returns. Investors receive some tax benefits, but at the expense of protection within their portfolio. Compare this to the benefits of non-callable default-free US Treasury securities. Holders of municipal or local government bonds need to examine carefully whether they are being compensated sufficiently for the risk in a fiscally uncertain, highly leveraged, low interest rate, negative real yield environment.

Jeremy Blatch TEP
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