VUSTX
Safety First
As investors get optimistic, riskier assets tend to outperform. As they get more pessimistic, safer assets tend to win. While there were some big ups and downs in the stock market in 2007, the real fear was in the bond market - the place where real estate bubble borrowing goes to find a buyer.
In 2007 investors started to question the likelihood that all these trillions in borrowing would get repaid. What started in real-estate-related debt moved to all consumer debt and even lower grade corporate borrowing. Where did all this newly conservative money flock? Good ole' Uncle Sam debt. That's right - capitalists favorite whipping boy, the government, is the investment of choice when the going gets rough.
Look no further than Vanguard for an indication how the bond market was in 2007. Vanguard Long-Term U.S. Treasury (VUSTX) was up 9.2%, while Vanguard High Yield Corporate (VWEHX) was up a paltry 2%.
But the real winner in 2007 was bond king Bill Gross, who's negative outlook on the economy and general suspicion of the fancy financial footwork in the housing market led his bond funds to a strong return in 2007, after a ho-hum 2006:
The Pimco Total Return fund that Gross runs scored a gain of 8.6% last year, a higher return than 90% of its peer bond funds -- and better than the 6.4% gain of the average stock fund -- after Gross' gamble that the housing crisis would force the Federal Reserve to cut interest rates paid off late in the last third of the year.
For the fourth quarter, Gross' fund returned 3.8%."
We've had a long-time Powerfund Portfolio holding in Bill Gross-managed Harbor Bond Institutional (HABDX), which was up 8.7% in 2007.
Bill Gross On Today’s Muni Bond Crash
Municipal bonds – which had been a model of stability and safety in investing - started sliding on February 12th. This was the day Money Magazine posted “Munis: The new power portfolio” and just days after Investor’s Business Daily penned, “Munis A Safe Haven While Bear Rampages”.
Yesterday, this slide turned into an avalanche. Many conservative municipal bonds funds fell between 1% and 2% and some leveraged closed-end municipal bond funds fell over 3%. Today promises to be worse than yesterday - troubling news because investors have been encouraged to buy municipal bonds recently to earn about 1% more after tax than safe treasuries. These investors have lost about 5% in the last couple of weeks in ordinary long term muni bond funds, and could be down in the double digits within a few days – to say nothing of the sixty billion or so in leveraged closed-end muni bond funds.
Bond kingpin Bill Gross or PIMCO fame appeared on the FOX Business Network’s “Cavuto” yesterday evening (in the segment after the one in which I appeared). He discussed yesterday’s wipeout in the municipal bond market and forecast that the real bloodbath would be today and perhaps Monday. Gross also predicted major buying opportunities in the next few days in munis:
Gross: There’s significant unwinds in terms of leveraged structures and the municipal market is in shambles. But it doesn’t mean that the credits themselves are not credit-worthy. And so if you can buy California at 5.5% to 6%, what an attractive value. Non taxable to the California holder. State of New York the same way.
These are values that probably won’t come around for another generation but they’re here at the moment. Yes, they’re risky because their prices are moving at the moment down. But they’re not uncreditworthy….
Cavuto: When do you start investing?
Gross: I think you start tomorrow. There’s 100s of municipal closed-end funds. Nuveen’s got some. Blackrock’s got some. PIMCO’s got some. They’re all out there. Tomorrow my forecast: They’re going to be hit hard.
Cavuto: Hit hard, responding to what?
Gross:Responding to these liquidations that are happening as we speak. Tomorrow will be a nasty day for the municipal market. For somebody who is willing to step in into a credit-worthy double A single A type of quality instrument that’s not going to default – cross your fingers – with no guarantees.
These values tomorrow and Monday and Tuesday of next week are going to be enormous."
What Bill Gross is talking about is highly leveraged hedge funds that have been buying up muni bonds and probably shorting treasury bonds.
The logic behind the trade is based on what many financial experts have been telling investors for the past few months: that municipal bond yields are historically high relative to treasury bonds – which is a good deal when compared to taxable treasuries for higher tax bracket investors.
For speculators it was a rationale to gamble. This yield gap between treasuries and munis should eventually converge, or so they thought, so shorting treasury bonds (which would make money if yields went up) and buying municipal bonds (which would make money if municipal bond yields went down) could make money with minimal risk because there is virtually no default rate on municipal bonds and no default rate on government bonds. General interest rate swings would not matter because both treasury bonds and muni bonds would move up or down together (assuming similar duration or interest rate sensitivity). The absolute ONLY risk was if municipal bonds yields went up while treasury yields went down…but why would that happen from already historically wide yield spreads between the two?
Well guess what happened yesterday? Municipal bond fund Vanguard Long-Term Tax-Exempt (VWLTX) was DOWN 1.21% (the fourth worst one-day drop in over a decade) while taxable government bond fund Vanguard Long-Term U.S. Treasury (VUSTX) was UP 1.49%! Now imagine being long munis and short treasuries with say, five times leverage. Doh!
We could have sworn we saw Bill Gross smirk at the trouble now facing the brilliant hedge fund managers. Watch the video closely. For those looking to follow Bill Gross’s lead and buy after the drop, consider unleveraged muni bond funds, like open end Vanguard funds, or closed-end funds that do not leverage, like Nuveen Municipal Value Fund (NUV).