When considering the risks of investing in bonds, investors tend to think of those associated with interest rates, credit quality, illiquidity, or inflation. But one risk that’s often overlooked has been prevalent throughout 2013: headline risk. It’s the risk that a news story will negatively affect the price of a bond, a fixed income sector, or the bond market as a whole. Headline risk is a more intangible sort of risk; it can affect not only one security but the entire fixed income market.
When the media talks strongly about a certain topic, investors may liquidate before really learning the details of the story. This was certainly the case in December 2010, when Meredith Whitney, CIO of the hedge fund Kenbelle Capital LP, predicted to 60 Minutes that there would be municipal bond defaults “in the hundreds of billions,” prompting investor anxiety and a steep sell-off in municipal bonds. In hindsight we know that these predictions failed to materialize (at least so far), but that didn’t prevent many investors from selling.
We’ve witnessed this risk become a stronger force in recent years, as the media issues ever more attention-grabbing headlines with stories designed to elicit emotional triggers and investor anxiety. And since today’s investors are living in a 24-hour news cycle, they’re able to access these stories with great ease through a variety of media. There have been many examples of headline risk throughout the past year, associated with news stories about municipal bond credit quality and default rates, the Detroit bankruptcy, Puerto Rico bonds, and rising interest rates. It can be difficult for investors to sort through which stories are relevant to their personal financial situation and which are simply noise. Let’s look at a few of these headlines in greater detail.
One of the biggest bond stories of 2013 was the Detroit bankruptcy. A particularly attention-grabbing headline on the front page of the Economist’s July 27 issue read, THE UNSTEADY STATES OF AMERICA, featuring a picture of a time bomb with the word Detroit on it. Equally dramatic was the August 5 cover of Time, featuring a picture of Detroit with the question, IS YOUR CITY NEXT? The story of Detroit’s financial situation is certainly a sad one, but it was hardly unpredictable, and the city’s situation appears to be unique rather than representative of the municipal market as a whole. Detroit’s population decline, unemployment rate, household income, and property value growth have been substantially worse than those of any other city.
Although other cities certainly face challenges, Detroit has been singular in the duration, multitude, and severity of the problems it faces. Overall, the credit quality of most municipal bonds is strong and has been greatly improved since the credit crisis; state and local governments continue to pay down debt and improve their balance sheets. Rising housing prices and new home growth have also helped municipalities, with property tax revenue increasing. According to the US Census Bureau, state and local tax revenues grew at 5.7 percent year over year in the second quarter of 2013—the highest rate since pre–financial crisis levels. Investors should not view the Detroit bankruptcy headlines as typical of the general municipal market.
Another top bond story of 2013 was the possible downgrade of Puerto Rico bonds to junk quality. As with Detroit, the situation in Puerto Rico appears to be the exception rather than the rule. One of the standout statistics with Puerto Rico is its unfunded pension liability. As of 2011 the commonwealth had only an 11.1 percent–funded pension level. Compare this to the 50-state median, at 69.8 percent, or the lowest US state, Illinois, at 43.4 percent, as reported in July 2013 by Standard & Poor’s. Once again, investors should consider the headlines about Puerto Rico a reason to avoid Puerto Rico bonds but not necessarily municipal bonds in general.
One of the most persistent bond stories in recent years has been fear over rising interest rates. Although investors should certainly be prepared for an increase in interest rates, we continue to recommend managing fixed income portfolios for income and moderate durations rather than trying to predict when interest rates will rise or avoiding bonds altogether, as some headlines seem to suggest. Even Warren Buffett weighed in on this matter in May, telling CNBC that “bonds are a terrible investment right now.
It’s important to tune out the more dramatic headlines and remember the benefits of fixed income investments: diversification from equities, consistent income, and preservation of capital. Although bond prices will fall when interest rates rise, avoiding bonds altogether would be a knee-jerk reaction and not in an investor’s long-term best interests. With that said, investors should take steps to prepare for an increase in interest rates. This may include purchasing bonds with higher coupons, targeting intermediate durations, and laddering bond maturities.
What Can Investors Do?
When you find yourself seemingly inundated with negative investment news headlines, it can be helpful to take a step back and avoid gut reactions. Do your research and consider how the story really affects you and your financial plan. Is the headline urging you to take actions that are well thought out or simply triggered by emotion? If your actions are fueled by panic, you may end up regretting them later. It’s also important to remember how quickly these headlines can go away. Following the initial sell-off associated with Meredith Whitney’s municipal bond default prediction in December 2010, the Barclays Municipal Bond Index returned 10.7 percent in 2011. Investors who are able to tune out headline risks may be rewarded for their dedication.