Asset Class: Municipal Debt

DON'T LIKE IT    

State and local governments also issue a wide variety of different debt instruments.  One type in particular, general obligation (GO) bonds, are considered very high quality, while also generally avoiding federal (and sometimes state and local) taxation.  Thus, many investors in high tax brackets favor municipal bonds over taxable bonds such as U.S. Treasury, corporate, or mortgage bonds.  For our purposes, municipal debt is not an adequate substitute for U.S. Treasury bonds.

While they have some positive characteristics, GO municipal bonds take a distant second place to U.S. Treasury bonds in reliably protecting capital during recession and/or deflation periods.  One reason is that even if credit risk is low, it is not zero.  For example, many cities rely heavily on real estate taxes, which can be problematic in a real estate downturn.  While you can argue that the Federal Government’s taxing power is correlated to that of states and cities, the Federal Government has two significant advantages: it is not required to run a balanced budget and the U.S. Treasury can create new money with which to pay its obligations.

Another disadvantage of municipal bonds is that many are callable, while U.S. Treasury bonds are not.  This means that the bond issuer has the right to redeem the bond from the investor prior to maturity, generally after interest rates have fallen and the issuer can sell new bonds at a lower rate.  This call feature limits the potential for price appreciation in municipal bonds, but not for U.S. Treasury bonds.  While many investors think about bonds in terms of income and not for price appreciation, long-term U.S. Treasury bonds can rise significantly if interest rates decline.  This can be very important for your overall portfolio if risky asset prices are declining at the same time.

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The preceding is an excerpt from the Modus Advisors Special Report titled, "Like It or Not? The Modus Advisors approach to Asset Class Investing".

You can download the complete report here.

We also have a podcast discussion of the report available here.