On Wednesday, I posted a chart of US Treasury Yields asking the question Yield Curve: Where To From Here? Extreme Complacency in Face of Bernanke Shift.

Today’s focus is on municipal bonds, but first let’s take a look at a chart from the above link.

Treasury Yield Curve

click on chart for sharper image

Certainly Bernanke is not hiking rates any time soon. However, that does not preclude upward pressure on long-term rates.

And if there is sustained upward pressure on interest rates (see the above link for why that may be the case), treasuries, corporates, and municipal bonds will all likely suffer.

With that thought in mind, please consider the following chart from Bloomberg on municipal bond yields.

US Municipal Bond Yields

click on chart for sharper image

Problematic Action

If I was a municipal bond investor, that chart would scare the hell out of me.

Yield on 30-year bonds plunged 90 basis points in the last year to 2.51% in what may have been a blow-off top of the muni market. Yields are sharply higher now, across the board.

Government debt is problematic enough, but at least there is no realistic default risk on treasuries.

So far, municipals have escaped the wave of defaults that Meredith Whitney announced, but even if the 30-year yield just goes back up to where it was, long-term municipals will not be a safe hiding spot.

Moreover, action across the entire muni-curve looks problematic. Yield on 10-year munis is up 33 basis points, yet still only at 1.75%.

Four Questions

  1. Is there any reason the yield on 10-year munis can’t climb to 3%? 
  2. Is there any reason the yield on 10-year munis shouldn’t climb to 3%?
  3. If the yield on 10-year munis does rise to 3%, do you want to be in munis?
  4. Where’s the value? 

One can hide out in 5-year munis, but the yield is a mere .85% on those. Action is likewise very problematic. In the last month, yield on 5-year munis rose 25 basis points.

Here are a couple additional questions to consider.

Just another Scare?

Of course this month’s selloff might be just another inflation scare. It might be another valuation scare. It might be another Fed hike scare. It might be another QE is ending scare.

However, this selloff might be the real deal: Recognition that the Fed is out of bullets, the Fed is getting nervous about its balance sheet, or the simple fact there is no conceivable value in holding 5-year munis for a lousy .61%, 10-year munis for a lousy 1.42%, or 30-year munis for a lousy 2.51% (where yields were a month ago).

Bubble in Munis?

I think any rational person would see there is no real value in 10-year yields at 1.42% . Yet, investors are wedded to them. In fact, to get the yields that low, investors had to be chasing them.

So yes, there is a bubble! Can the bubble get bigger? Certainly! Why can’t it? Will it? That I cannot say, but for those in munis, that appears to be the bet.

In a way, this is not much different than people chasing technology stocks in 1999 or houses in 2006. In another way it’s different. There is rightful aversion to stocks, and for most investors, bonds are the only other game in town.

Moreover, some people are in bonds just because they will not accept 0% in cash, and they simply have not pondered valuations, inflation, the effects of QE, or any other factors.

Bill Gross Chimes In

Researching this article, I came across Wisdom from the Bond King, an interview on US News and World Report. Emphasis in italics is mine.

Since 1971, Gross, 68, has deftly steered PIMCO, the Newport Beach, Calif., investment firm that he cofounded and where he is currently co-chief investment officer, overseeing some $1.8 trillion in assets. He manages PIMCO Total Return Fund, the world’s largest mutual fund and a stalwart of the fixed-income world that has returned more than 7.3 percent annually over the past 15 years, helping to earn Gross the unofficial title of “bond king.” Gross recently spoke with U.S. News about what he sees as a “new normal” for the markets and for investors. Edited excerpts:

What have you done that has accounted for the Total Return Fund’s impressive and continued success?

To be fair, the near double-digit returns are a function of falling interest rates more than anything else. It’s sort of like a teeter-totter; when interest rates go down, prices go up. So the Total Return Fund, [just] as all bond funds, has done well in part because interest rates have gone down, down, down. We’ve also outperformed the [investment-grade bond] market by close to 2 percentage points a year. Individual strategies in terms of trading hopefully account for the track record. That leads, I guess, to another question: Can those returns be duplicated going forward?

I imagine that’s on a lot of investors’ minds. What should they expect?

You start with the obvious: The Federal Reserve has lowered short rates to close to zero. The investment-grade bond market, which includes treasuries and corporates and mortgages, all in one big pot, yields 1¾ percent. It’s hard to manufacture near double-digit returns from that. It’s the metaphorical concept of squeezing juice out of an orange; almost all of the juice has been extracted, so to speak.

So investors looking for a repeat of historical performance are bound to be disappointed, and that’s why I wrote several months ago—which caused a ruckus in the market—about the [dying] cult of equity. It was the same thing with the cult of bonds, the “cult” meaning that there was a belief that historical returns could be projected into the future. They can’t. They can’t for bonds and they can’t for stocks either, in my opinion.

What’s your economic forecast for the months and year ahead?

An investor probably has to look forward to higher inflation. Slower growth and higher inflation—that’s not a positive, by any means. Individuals would want it to be just the reverse. The de-levering and the check-writing on the part of central banks, that’s really what produces the situation.

Are you worried about debt in the United States and Europe?

Slow growth and inflation have a tendency to accompany large deficits and increasing debt as a percentage of GDP. Unless we begin to reverse that course, we could resemble Greece within a decade.

Final Thoughts

I do not foresee the inflation Gross does, at least not yet (and my track record on that score has been quite good).  However, my definition of inflation involves credit, not prices.

Regardless of definitions, even if this action is nothing more than another inflation scare, I would not want to sit through the scare for the simple reason yields have a long way to rise before there is any conceivable value in them.

Readers will note that I had generally been bullish on treasuries, but I do not like them now either. There simply is no value, even if the US is back in recession, and especially if the end of QE awaits.

Thus, there is a lot of merit in saying to hell with it all and sitting in cash. Of course I would have said the same thing about munis a year ago. And I would have been overly-cautious then. Am I overly-cautious now?

Regardless, we are currently at a point where being wrong can be extremely costly. And with each drop in yield, the more likely sitting on the sidelines earning nothing is likely to be right.

From my perspective, earning 1.42% on 10-year munis is not worth the risk of being on the wrong side of a major move, whether or not bonds are the only game in town.

Mike “Mish” Shedlock

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