Friday, December 4, 2009

Bonds can be risky too!

Most people thought that government bonds, those issued by the Feds, State, or Municipalities are about as safe as they come, and often TAX FREE, making them very attractive in bad economical times when stocks are too volatile, but keep in mind that not all bonds are created equal, and bonds CAN be risky.

Forbes Magazine, October 5th, 2009 issue, page 30, has an article called "Potemkin Village". For the whole thing, you'll have to read the magazine, but I'll summarize for you... Some so-called "municipal bonds" are actually community development district bonds. The CDD bonds are issued by a conglomerate of bankers, land owners, home builders, and developers, with approval of local government, to build expensive communities with golf course, tennis courts, country club, lots of houses, roads, and so on. When the real estate market went bust, it took out a LOT of CDD bonds with it, because the builders won't build houses any more, seeing no profit in it, and without houses, the whole thing goes kaput.

And don't think these are small builders. Pulte Homes (and its subsidiary, Centex), D.R. Horton, and some of the largest home builders in the US of A are involved in some of the biggest failed land developments in Florida in recent years. Even Bank of America's underwriting division underwrote some of these bonds.

Some bond managers are dragging the thing out by dipping into reserve funds to keep paying the "dividends", even though those are meant to be used for cost overruns and such. But even those will soon run out.

If you have "conservative" mutual funds, you should check its portfolio, esp. if they have any municipal bonds. These CDD bonds, also known as "dirt bonds" because the bonds just have some land as collateral, are major portions of many "conservative" mutual funds, such as Oppenheimer's Rochester fund. The question is... how much are those lands (and unfinished foundation) worth, and are they really worth about 50 cents on the dollar the funds are holding them for nowadays?

You have to keep in mind that these fund managers will NOT exactly tell you about the risks they are taking with your money. A year ago Oppenheimer released an annual statement for the fund stating that they see NO problem with the municipal bond market. The tone did not change six months ago either. Instead of selling their dirt bonds (already at almost 19% of their holdings), they are buying more, even as the prices of those bonds drop, now to about 50 cents per dollar.

The fund managers are not crazy either. They think the CDD's have a good chance to turnaround with the revival of the real estate market. And if all else fails, they can always go in and seize all the unbuilt properties from the land owners and try to sell the land later and/or hold them as "asset plays". However that is getting away from the spirit of municipal bond as safe way to invest but instead is getting into a bit of speculation, as the Forbes article pointed out.

The "point" I am trying to make is NOT to cast doubt on municipal bonds, but just to illustrate that NOTHING is clear-cut. For the longest time you hear things like "stocks are risky; bonds are safe". But there are risky stocks, and there are safe stocks. There are risky bonds, and there are safe bonds. Risky stuff can become safe ones, and safe ones can become risky ones. It is up to YOU to keep on top of your investments, and if the fund changes its strategy and its risk profile, it is up to you to keep track of that as well.

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