Detroit's bankruptcy is far and away the largest municipal
bankruptcy ever. In fact, it's more than four-times the size of
the second biggest bankruptcy - the $4 billion default by
Jefferson County, Alabama.
Now, most bond funds will avoid considerable losses since
they're so diversified. And many Detroit bonds were
"insured" and the insurance company will cover principal losses.
But that doesn't really matter.
Detroit isn't the reason to sell municipal bonds today. There
is a far more important reason that these bonds pose a risk to
your investment portfolio. Let me explain…
In yesterday's edition of
Income & Prosperity
Detroit and The Risk of Chasing Yield
- I explained that investors bought Detroit bonds for the extra
Many investors favor municipal bonds over Treasuries for the
same simple reason: higher yields. The following chart shows the
yield of AAA rated municipal bonds compared with U.S.
On top of the higher yield, municipal bonds offer the distinct
advantage of being tax-free investments. This is
particularly advantageous for investors in high income tax
brackets. Being able to avoid federal and state income taxes can
add to the already superior yield.
Now, investors in AAA rated municipal bonds face little risk
of default. That's because AAA-rated municipal bonds have the
same historical likelihood of default as U.S. Treasuries at
That's right - no municipality with AAA-rated bonds has ever
gone bankrupt. Nor has the U.S. government, with its
current AA+ credit rating from Standard & Poors.
But credit risk isn't the reason to sell munis. Of course
there will be more bankruptcies, some big and others small.
But I'm not particularly worried about the impact of another
Detroit or Jefferson County Alabama.
interest rate risk
that has me running away from muni bonds. And it's a mistake for
investors to focus on the Detroit bankruptcy, while overlooking
this looming threat.
Long duration bonds will fall considerably if interest rates
rise. And the type of bond - Treasuries, munis, or corporate -
doesn't really matter at all. In
Slow Death vs. Fast Death in Bonds
, I told you:
The yields on bonds are rising, and when they do, principle
prices fall. As we saw recently, yields have started
increasing with just a few comments from the Fed Chairman.
Consider what might happen when Bernanke raises the prime
rate on Federal funds from 0.25% today to a more reasonable 1%
or 2%. It could happen sooner than you might think. When that
happens, the 13% losses experienced in the last two months will
If you own AAA rated municipal bonds, you're earning 1% more
than Treasuries. Plus, you're getting a nice tax benefit. And you
don't even have to worry about the risk of default.
But you better be prepared for lost principal value when
interest rates start rising. Even AAA bond ratings and bond
insurance won't help when the Fed starts raising rates.
The end of QE3 - also known as Fed tapering - is just the
start. Looking forward a couple years, interest rates will
actually start ticking up. And when they do, you won't want
to be holding Treasuries, municipal, or even corporate bonds with
It's far better to sell before this rising interest rates get
P.S. Send me your thoughts on the Detroit bankruptcy.
Plus, tell me how you're protecting your investment portfolio
from rising interest rates. My email address is
email@example.com - I look forward to your