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Should You Steer Clear of Bonds During COVID-19?

Should You Steer Clear of Bonds During COVID-19?

The American College of Financial Services
July 22, 2020

As the stock market continues to fluctuate and the economy drags on up the slow road to recovery, advisors and their investor clients are having to relearn the rules of the road when it comes to portfolio management. Investments that up until a few months ago looked like a safe bet have now been turned on their head, and it’s required a re-evaluation of portfolios for many Americans.

In a May 28, 2020 webcast from The American College of Financial Services discussing COVID-19’s effect on wealth management, Michael Finke, WMCP® program director at The College, asked about the status of municipal bonds based on local governments, or munis. Historically, munis have been seen as solid investments, but with the pandemic hitting cities and towns across the country hard and financial regulations changing on an almost weekly basis, Finke questioned whether munis are too much of a risk these days for most investors.

Larry Swedroe, Chief Research Officer at Buckingham Wealth Partners, said while there have always been certain states and municipalities whose bonds investors should avoid in favor of more stable ones, COVID-19 has thrown the entire market into disarray.

“A lot of them are going to face problems because their revenues are way down, their income tax is likely to be a lot lower, and their value with pensions have gone down. Most of them, I think, have too high assumptions on the rates they expect,” he said. “Municipalities are going to have to be forced to make more contributions, which stresses their budgets. Right now, you really need to stick with the highest quality and do not stretch for yields with munis.”

Economic expert Laurence Kotlikoff agreed with Swedroe, and stressed the impact pension benefits will have on the value of munis.

“When people look at the unfunded liability there, they may think they’re going to earn 7% or 8% on their investments, and then they don't put enough money into the pension fund to cover that liability,” he said. “With the TIPS (Treasury Inflation-Protected Securities) rate negative in the short term and probably zero in the long term, we’re talking about crazy small numbers compared to what the truth is of valuations. I would be very careful with investing in any state government where I haven't done a real full fiscal gap analysis.”

To do this, Kotlikoff said, wealth managers need to ask the right questions.

“What are the true outlays going forward? What are the true receipts? What do things look like when you risk-adjust everything?” he said. “Personally, I would stay away. It's just too dangerous right now, especially since our national administration hasn’t been doing much to help out the states. This is not a good time to be in munis.”

All in all, Swedroe says it’s a grim picture for bonds of many kinds right now, and wealth managers should be working to reduce risk in portfolios from the equity side.

“There could be a second or third wave of the virus that creates bigger risks than the market is anticipating now, and if we get that, then you've got serious problems for the stock market and very high valuations,” he said. “At that point, even corporate bonds become at risk, and munis are worse than ever. Now, if you want to sell equities and take a little bit more risk in bonds, that's still reducing risk somewhat, but if you're stretching for yield to take credit risk, then it should come from the equity portion of your portfolio, not from the safe bonds.”

 

Giving You the Confidence Knowledge Provides

 

At The American College of Financial Services, we’re working to bring you the latest information from the foremost experts in the field as we all face this once-in-a-generation crisis together. For more of this conversation featuring Michael Finke, Laurence Kotlikoff, and Larry Swedroe, watch the full webcast below from May 28, 2020.

In addition, you can download our free e-book, “Financial Planning During COVID-19,” for total access to all transcripts and on-demand webcast links.

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