Focus on What You Know and Can Control: Be Aware of Unexpected Risks in Bonds

June 14, 2013
Warren pierson
Warren Pierson
Senior Portfolio Manager

Warren Pierson has more than 25 years of fixed income experience. In addition to his work for with Baird Advisors, he is one of the managers of the Baird Funds.
Municipal Credit Fundamentals Remain Challenged
Unlike the corporate bond sector, which has seen steadily improving fundamentals, challenging credit conditions persist for municipal investors. Revenues continue to be soft due to the moderate growth we are experiencing in the economy. Additional stress from federal budget deficit reduction efforts will have a domino effect on state and local budgets. The result is that municipal downgrades now outnumber upgrades by a ratio of 6-to-1, and state downgrades outnumber upgrades by 4-to-1.

Chapter 9 bankruptcies, once unheard of, are increasing and could set frightening precedents that few municipal bond investors expect. In California, CalPERS, the state pension fund, is jockeying for position ahead of some bond holders. These potential outcomes are not fully priced into bond prices – should they come to fruition, it will be even more expensive for municipalities.

Durations on Some Municipal and Agency Mortgage-Backed Bonds Could Extend Quickly in a Rising-Rate Environment
Interest rates are at historic lows and unlikely to go down much lower. At some point, rates will begin to rise. This creates a potential challenge for holders of callable bonds and agency mortgage-backed securities. When rates rise, bond issuers are less likely to call a bond at par. These bonds will be repriced to longer maturities. On the agency mortgage side, bond holders can experience negative convexity. As fewer homeowners refinance their homes, the average life of a portfolio of mortgages extends. During a period of rising rates, the result will be bond portfolios that quickly price lower to much longer durations.

Few municipal or agency mortgage bond investors expect the resulting negative performance of portfolios due to this extension risk. Returns and principal value can be quickly reduced.

Bond Investors Should Stick With Higher-Quality, Non-Callable Bonds
Given the significant risk of downgrades and the potential for rising rates sometime in the not-too-distant future, investors should stick with higher-quality, non-callable bonds. Yet market flows suggest that many investors continue to stretch for yield by buying lower-quality or longer-duration bonds with shorter call provisions.

Suggested Alternative Strategies
  1. Invest in high-quality, non-callable municipal bonds with short to intermediate maturities.
  2. Consider higher-quality mortgage- and asset-backed securities to find additional yield and return potential. Be aware of extension risk.
  3. Consider alternatives such as non-callable short and intermediate investment-grade corporate bonds with strong credit fundamentals. Here, diversification is important to help control credit risk.

Key Takeaways

While corporate bonds have seen steady improvement in credit fundamentals, similar improvement has not taken place for municipal bonds. Ongoing challenges in municipal credit could have a meaningful negative effect on municipal bonds.

>Many callable bonds with longer maturities face significant extension risk with an upward movement in interest rates. Durations currently pegged to shorter call dates could extend sharply as issuers are less likely to call in bonds prior to maturity as interest rates rise. As callable bonds get repriced to longer maturity dates, the resulting price declines could be profound.

Likewise, many mortgage pass-through securities will not be repaid early in a rising-rate environment. Bond portfolio durations, calculated on repayment schedules, could also quickly extend.

Investors should stick with high-quality, non-callable bonds or carefully selected mortgage-backed securities with lower extension risk.



Important Disclosure Information

The suggested alternative strategies may help protect principal in a rising-interest-rate environment and allow an investor to capture higher yields. But there are risks involved with this strategy, including but not limited to changes in interest rates, liquidity, credit quality, volatility and duration. Investments in mortgage- and asset-backed securities include interest rate, prepayment, extension and default risks. Investments in non-investment-grade debt securities include risks such as increased credit risk and higher risk of default or bankruptcy.

Municipal bonds may be used to fund expenditures such as the construction of highways, bridges and schools. Municipal bonds are generally exempt from federal taxes and most state and local taxes, especially if the investor lives in the state in which the bond is issued. For this reason, municipal bonds are popular with people in high income-tax brackets. Some of the potential risks associated with municipal bonds include call risk, reinvestment risk, default risk and inflation risk. Additionally, it is important that an investor is familiar with the inverse relationship between a bond’s price and its yield. Bond prices will fall as interest rates rise and vice versa.

Diversification does not ensure against loss or guarantee a profit. Past performance is not a guarantee of future results.