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Municipal Bonds: Fed’s September Hike Delay and Puerto Rico Default

TOM BUTCHER: The Federal Open Market Committee (FOMC) has decided to do nothing with interest rates. How will this affect the muni market going forward?

JAMES COLBY: I think the market is going to be disappointed. We've been waiting for two-and-a-half years for the Federal Reserve (Fed) to make a move. For reasons that are probably pretty clear, they've chosen not to adjust rates. Consequently the municipal market has been on hold for the better part of six months. Flows either have flat lined or have been slightly negative into investments such as muni ETFs and mutual funds. Investors are looking for yield and an opportunity to invest. They're looking for something different and the evidence indicates that perhaps they are looking at other asset classes. Hopefully, in the fourth quarter of this year investors will revisit munis and see the value that is inherent in muni bond investments. I daresay that disappointment will prevail in the short run.

BUTCHER: How can municipal bonds provide investors with stability in a rising interest rate environment?

COLBY: History suggests that if you look back at the asset class in terms of its performance, i.e., its long-term performance versus other asset classes, munis are far less volatile over several different interest rate cycles compared to corporates or equities, for example. The reason for this is perhaps twofold. Number one is the structure of municipal bonds. Bonds tend to be callable and have relatively short calls; therefore their price doesn't vary in a significant way over time. Secondly, individuals own the majority of muni bonds and they often hold onto these bonds and don't sell them, whether they are held as individual securities or through packaged investments such as ETFs or mutual funds. Very few bonds that get issued in this marketplace trade much beyond three, four, or five years from the time of issuance. There is a degree of stability in the municipal marketplace. It's something that investors should consider when deciding how to allocate investments, redistribute volatility, and mute the impact of interest rate changes, which everyone is anticipating.

BUTCHER: Turning to Puerto Rico, do you have any comments on its declaration that debt restructuring needs to take place?

COLBY: It's a proclamation in the sense that the Commonwealth of Puerto Rico now is admitting to the world something that we've all known for some time: They are at best going to struggle to meet their obligations. Presently the Commonwealth likely has no ability to meet its obligations without significant changes, which might be changes to their constitution or changes promulgated in Washington, D.C. to give them the authority and ability to affect restructuring. There is talk right now between one of the prime issuers in the Commonwealth and some significantly large bondholders about restructuring a particular obligation, the electric authority. The rest of the issuers in the Commonwealth have yet to undertake such conversations. It’s unclear exactly how that's going to go. The declaration that came out deals with that. It's a statement that we're to expect negotiations to take place over the next many months; the outcome will be up in the air and uncertain.

BUTCHER: It’s purely a declaration then.

COLBY: Exactly.

BUTCHER: Jim, thank you very much.

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