Saturday, September 27, 2014

5 Reasons Why Short-Term Municipal Bonds Make Sense Now

1000 frank holmes
Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors writes:

Last week Federal Reserve Chairwoman Janet Yellen insisted that record-low interest rates will stay as they are for a "considerable time." So what does that mean for bond investors? Many people realize that rising interest rates affect yields and prices, but what others might not know is that if you stick closely to short-term, investment-grade debt securities-the very kind our Near-Term Tax Free Fund (NEARX) invests in-the impact of such a rate hike is not as dramatic as some investors might think.

As you can see in the chart below, NEARX has been a steady grower over the years, in times of rising and falling interest rates as well as extreme market downturns. In fact, it's taken nearly a decade and a half for the S&P 500 Index to surpass NEARX using a hypothetical $100,000 investment back in June 2000.

Think of NEARX, then, as the emotionally-stable, no-drama fund.

Near-Term Tax Free Fund vs. S&P 500 Index
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Take a look at the latest performance of the fund here.

Although short-term bonds might not be as sexy as common stocks in fashionable brands like Apple and Tesla, they play an important role in any serious investor's portfolio. Below are five reasons why investing in municipal bonds makes sense now more than ever.

1. Short-term, investment-grade municipal bonds are less volatile in a climate of rising interest rates.

Interest rates are currently at 50-year lows, but as I wrote about previously, they can't stay near zero forever. And when rates do rise, bond prices will fall. At first glance, this inverse relationship might seem illogical, but it makes sense. If newly issued bonds carry a higher yield, the value of existing bonds with lower rates fall.

Let's imagine the Fed raised rates tomorrow. What potential implications would that have on the yield curve and bond prices? As you can see in this hypothetical example using a two-year, 10-year and 30-year Treasury, the farther out the maturity date and higher the rate hike, the more your security would be affected. Remember, these are Treasuries, not municipal bonds, but munis could be similarly affected.

the Longer the Maturity, the Greater the Price Volatility
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As you might guess, what this indicates is that investors should take advantage of short-term bonds, which are less sensitive to rate increases than longer-term bonds that are locked into rates for greater periods of time.

I want to reassure investors that when the Fed raises rates next year, as many economists and analysts speculate, it will most likely be done incrementally over the course of several months rather than in one fell swoop. Just as deep sea divers risk getting the bends when they surface too fast, there's economic risk in allowing rates to rise too much too quickly. The Fed is well aware of this.

Below is one research firm's projection of what rates might look like at different time periods in the future. As you can see, the probability of higher rates rises gradually over time. Some readers might perceive this forecast as too dovish, but it makes the point that an unexpectedly huge rate hike that some investors fear is unlikely.

Probability of an Interest Rate Hike
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What the chart also shows is that there's still time to gain exposure to short-term securities, which are less sensitive to interest rate hikes. NEARX not only invests in such securities but is actively managed by professionals who closely monitor the bond market and interest rate environment.

John Derrick, Director of Research at U.S. Global Investors and portfolio manager of the Near-Term Tax Free Fund, stated during his recent interview with Oxford Club Radio that rising interest rates can actually work in the fund's favor: "When interest rates rise, we'll try to step in and use that volatility to our advantage. You just try to be prudent about how you position duration and maturity structure."

2. Investment-grade munis have a low default risk.

In 2013, your chances of investing in a reliable, secure municipal bond from an issuer that wouldn't default were roughly 99.9 percent. That's according to the number of bond issues in the S&P Municipal Bond Index that defaulted last year. Out of more than 21,000 bonds in the index, only 23 failed to meet their payment obligations.

In the table below, you can see there's a greater likelihood that an issuer won't default the higher its rating and the shorter its maturity. Bottom line: these securities are relatively safe.

Muni Bond Issuers' Cumulative Default Rose by Initial Moody's Rating
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In a July Frank Talk, John held that:

"On a tax-adjusted basis, municipal bonds have a very compelling risk-reward profile, which means the risk-adjusted returns are high. To take advantage of this, I would encourage investors to add exposure to their portfolio by investing in a product that holds high-quality, traditional municipal bonds."

John reiterated this point during his interview with Oxford Club Radio: "At the end of the day, we stick to the high-quality munis. We really don't play in the higher yield front, where there's more of a risk of a correction."

3. Municipal bonds are tax-free at the federal level.

As you might already know, munis are typically exempt from federal income taxes and often from state and local income taxation as well. This fact is especially appealing to high net worth individuals who want to minimize the tax impact on their investments.

That means more money stays in your pocket and can be reinvested.

4. Munis help diversify your portfolio.

Diversify, Diversify, Diversify.It's prudent to have a diversified portfolio of both equity and debt securities, not to mention cash and commodities such as gold. Stocks can offer you growth and capital gains while bonds provide income and can help protect your assets during more volatile times.

Even within the bond portion of your portfolio, it's important to diversify the types of debt securities you're investing in. NEARX, for instance, holds a wide range of municipal bonds, from school districts to transportation to utilities.

"We're buying high-quality municipals, GOs [general obligations] and essential service revenue," John says.

He likes to describe NEARX as a "classic municipal bond fund."

"We operate in a very conservative manner, probably much more so than most of our peers. It's not the kind of fund where you're going to wake up one day and find that some high-yield security has blown up."

5. Municipal bonds help make America strong.

Speaking of schools, transportation, utilities and other projects, bonds help state and local governments build, repair and maintain much-needed services. This is one of the most compelling reasons to invest in short-term, investment-grade munis. Not only do they have an attractive risk-reward profile and offer tax-free income, they also ensure that municipalities have the funding to provide their citizens with essential needs like education, roads and energy and help build their communities.

Below you can see what some of the largest bond issuances are earmarked for. Without exception, the revenue that bonds generate goes toward services that make America's states, counties and cities attractive places to live.

Municipal Bond Issuances for the 21 Largest Infrastructure Purposes
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Also, there's reason to believe that issuing bonds is the most effective way for governments to generate the funding necessary for specific undertakings. In a recent POLITICO Magazine article entitled "Are Conservative Cities Better?", columnist Ethan Epstein shows that whereas some cities and municipalities rely on and raise taxes indefinitely to fund projects and programs, others prefer instead to issue bonds because they're intended for only one sole purpose:

"[B]ond issues go to specific projects, and cover only a specific amount of money. That's different from funding a social program, or simply forking over higher taxes and hoping that the extra funds go where the government says they're going." "People are OK with investing in their communities," says former Mesa, Arizona, mayor Scott Smith, adding, "People don't trust programs. They trust...tangible results."

However one feels about social programs, Mayor Smith's point is clear: bonds do precisely what they're designed to do, namely, fund projects such as hospitals and roads that benefit all citizens, young and old, rich and poor.

Take a Look at NEARX.

Our Mear-Term Tax Free Fund is unique for its floating $2 NAVThe Near-Term Tax Free Fund recently received the coveted five-star rating from Morningstar for the three-year performance period in the Municipal National Short-Term category, and it's been rated four stars overall for many years. The turnover of NEARX is very low, and it has performed well against its peers. Additionally, the fund seeks preservation of capital and has a floating $2 net asset value (NAV) that has demonstrated minimal fluctuation in its share price.

For those investors who wish to seek tax-free income and portfolio diversity and who want to take an active role in strengthening America's infrastructure, I encourage you to request an information packet.

Remember to sign up for our October 2 webcast, "One World Market, Many Central Banks: How Will Your Investments Be Impacted?" Participants can receive a continuing education (CE) credit. Also, be sure to download my latest whitepaper, "Managing Expectations: Anticipate Before You Participate in the Market."

Stay curious!

Gold Market

For the week, spot gold closed at $1,218.07 up $2.37 per ounce, or 0.19 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, fell 2.74 percent. The U.S. Trade-Weighted Dollar Index rose 1.04 percent for the week.

DateEventSurveyActualPrior
Sept 22 HSBC China Manufacturing PMI 50.0% 50.5 50.2
Sept 24 US New Home Sales 430K 504K 427K
Sept 25 US Initial Jobless Claims 296K 293K 281K
Sept 25 US Durable Goods Orders -18.0% -18.2 22.5%
Sept 26 GDP Annualized QoQ 4.6% 4.6% 4.2%
Sept 29 Germany CPI YoY 0.8% -- 0.8%
Sept 30 Eurozone Core CPI YoY 0.9% -- 0.9%
Oct 01 US ISM Manufacturing 58.3 -- 59.0
Oct 02 ECB Main Refinancing Rate 0.5 -- 0.5
Oct 03 US Change in Nonfarm Payrolls 215K -- 142K

Strengths

  • Gold mint sales are on the rise. This week, the United Kingdom's Royal Mint launched an online bullion trading website for the first time. The move is aimed at accessing unsatisfied gold demand in the UK. The Mint's gold coin sales have increased after being granted value-added-tax-free status in the UK. In the United States, gold coin sales are on the rise as well. Thus far in September, sales of American Eagle bullion gold coins have increased 84 percent from August.
  • Central banks remain attracted to gold. Russia announced that its central bank has added another 9.3 tonnes of gold to its reserves. Russia has almost doubled its gold reserves since the financial crisis, being a net buyer every month since. Furthermore, European central banks have retained much more gold than they expected, unloading just 1.7 percent of the gold allowed in their agreement to limit sales.

Russian Central Bank Continues to Add to its Gold Holdings
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  • Roughly 50 tonnes of gold have been smuggled into India over the past ten days according to the Hindustan Times. The substantial inflows into the country stem from the seasonal demand for gold and highlight the resilient demand for the precious metal in India.  Premiums for gold in India are anticipated to double to $20 per ounce over the London cash price going into October.

Weaknesses

  • South African platinum mining stocks fell to their lowest level since 2013 as metal prices continue to be depressed. The three largest platinum producers have also been unable to fully recover their production from the previous five-month strike.
  • Down 12 percent this quarter, commodities are poised for the biggest decline since the financial crisis. Weak global growth data from Europe and China as well as a strong dollar have created severe headwinds for the asset class.
  • The ETF that tracks the Market Vectors Junior Gold Miners Index, the GDXJ, is reportedly too large to match the benchmark. Most of the fund's holdings have exceeded 10 percent of the outstanding shares, causing the need for the ETF to rebalance to an asset mix that departs from its benchmark.

Opportunities

  • The World Gold Council says that gold will rebound by the end of 2014. The confidence in gold expressed by the council is due to the strong demand from India during the current wedding season. The council is forecasting demand figures in the range of 850 to 950 tonnes.
  • A recent report issued by McKinsey and Company argued that the diamond industry will likely continue to be a strong and profitable one. In the near future, demand growth will outstrip supply.
  • Desjardins Capital Markets issued a report on Mandalay Resources, identifying the company as a 'top pick."  Desjardins expects production to grow over 50 percent by 2015.  Mandalay sports a P/E of just 11 relative to the S&P 500 at 18.  In addition, Mandalay has a dividend yield of 3.5 percent.

Threats

  • According to Goldman Sachs Group's Jeffrey Currie, gold is set to continue its decline. He argues that gold has been supported recently by geopolitical tensions in Ukraine, which are now fading. Investors are also shying away from gold as the dollar continues to appreciate and commodities as a whole suffer. Despite gold being unable to find many buyers during its recent slump, Mohamed El-Erian, Chief Economic Adviser at Allianz, noted today in an editorial that "only brave investors would omit it from their investment portfolio given the fluid world we live in."
  • Norilsk Nickel is looking at buying palladium from the Russian Central Bank. Uncertainty surrounding the deal, which is expected to amount to 2.4 million oz., may push palladium prices lower. Furthermore, whereas it was uncertain to what degree the Russian Central bank was holding palladium, this deal now reveals that the bank holds a substantial position in the metal.
  • The Central Bank of Japan (BOJ) has reportedly purchased a record amount of Japanese equities. Holding 1.5 percent of the entire Japanese equity market, the BOJ's aggressive purchasing leads one to speculate as to whether or not the U.S. Federal Reserve is doing the same. Since higher equity prices would directly enhance the wealth effect, thus raising consumer confidence, it is not beyond reason to consider.

September 26, 2014 (Source: U. S. Global Investors)

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The Original
Vulture Speculator

Trading gold, silver and mining shares since 1980 with a focus on taking advantage of volatility extremes, Gene Arensberg analyses the markets through a basket of technical and fundamental indicators and shares his findings from time to time here at Got Gold Report. Mr. Arensberg has been quoted in the Wall Street Journal, Dow Jones MarketWatch, USA Today and dozens of other news organizations.

"I've been a huge fan of Gene and his amazing work for years..."

Brien Lundin, CEO, Jefferson Financial, Host of the annual New Orleans Investment Conference and Publisher of Gold Newsletter


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