While there have been temporary dislocations in the municipal bond market in the past – hysteria about a flat tax roiled the sector in the early nineties – prices on federal tax free debt historically have proven to be less vol-atile than government, agency or corporate bonds. This only makes sense as muni investors tend to be “buy and hold” accounts interested primarily in safety of principal and competitive tax-advantaged income, whereas the taxable market is home to many more aggressive institutional traders interested in flipping government and corporate debt for capital gains. As is well known, however, past performance does not guarantee future results.
Several developments, unforeseen by most participants just six months ago, have not only triggered a new round of volatility in the municipal market but also resulted in a meaningful divergence in performance within the sector. For one, yields on short-term issues have begun to fall, following reductions in closely-linked overnight rates by the Federal Reserve. Last week alone, strong demand for less-volatile one-year investment grade paper translated to a significant yield decline of nearly 40 basis points to 1.50% according to Bloomberg.
Conversely, the longer end of the municipal yield curve has not reflected the ongoing rally (lower yields/higher prices) in benchmark Treasuries as it normally would, become less liquid and dominated by sellers of lower quality issues and potential downgrade candidates. The major reason for the underperformance in intermediate and longer term munis, we believe, is concern about the viability of bond insurers.
Bond Insurer Problems Remains An Ongoing Story
As their name suggests, municipal bonds are issued by states, cities and other public agencies to finance construction projects, such as airports, roads, sewers and related services people use every day. The “tax exempt” status on interest paid investors dates back to the early 1800’s and has been instrumental in allowing municipal issuers to borrow money at lower rates.
Although the vast majority of municipalities don’t need to insure their bonds against default (a fact which is reinforced by historically low default rates), they do so because it enables them to capture an AAA credit rating, issue bonds at lower costs and help support a more liquid market for secondary issues. According to the Wall Street Journal, approximately half of all municipal bonds carry some sort of insurance.
For decades, insuring municipal debt was a win/win situation for both municipalities and the seven private municipal bond insurance companies – Ambac Assurance, Assured Guarantee, CIFG Guaranty, Financial Guaranty Insurance Company (FGIC), Financial Security Assurance (FSA), MBIA Insurance and XL Capital. Municipalities reduced their borrowing costs and benefited from the highest ratings from the credit agencies while insurers collected attractive premiums and paid out very little in claims.
This all changed, however, when the insurance companies, in the hunt for more revenues, decided to start guaranteeing riskier mortgage and structured products known as collateralized debt obligations (CDOs). Born earlier in the decade during the great real estate boom, CDOs are pools of different types of higher yielding bonds and mortgages that underwriters insured to attract more conservative dollars.
As more and more homeowners failed to make their mortgage payments, concerns grew about the ability of bond insurers to cover missed interest and principal payments should the mortgage crisis really deepen. According to Bloomberg, total subprime-related losses for bond insurers could be as much as $65 billion and the companies would need an aggregate $130 billion to cover their losses and recapitalize. These are truly staggering figures and the industry currently doesn’t have these kind of resources.
The major ratings agencies (Standard & Poor’s and Moody’s), who have come under criticism for not recognizing the potential landmines in these complicated investment structures sooner, have begun downgrading some insurers on concerns about their ability to reimburse holders of certain mortgage and collateralized debt obligations. Absent some sort of government-orchestrated bailout, infusion of private capital and/or regulation modification in the near-term, further credit downgrades for insurers or worse is likely.
Situation In The Municipal Market Very Different From The Mortgage Sector
The two largest insurers of municipal bonds, Ambac and MBIA, have carried AAA credit ratings for decades. Fears these ratings will be lowered in the coming months has forced many institutional investors to sell some of their insured munis because they can only hold AAA rated bonds by covenant. Over the last several quarters, the bond market has begun repricing many AAA insured issues down to price levels (higher yields) they would trade on a “stand-alone basis” or without insurance. This is the reason why certain AAA rated insured municipal bonds have not participated in the ongoing “flight to quality” rally in the bond market.
Because most municipalities that have issued insured debt have solid finances and the wherewithal to make timely principal and interest payments, the ongoing insurer crisis has actually created selected buying opportunities. Clearly, some municipal issuers, especially smaller entities, are going to be hurt from the subprime crisis and this is something which needs to be monitored closely. But newer investors must understand insurance companies have nothing to do with the ability of issuers to make principal and interest payments. These monies come directly from the issuer and are paid by collected taxes or project revenues. Obviously, this is a very different set of circumstances than the potential disaster now weighing on holders of certain subprime mortgages and CDOs, investments we never got involved with.
New Municipal Bond Purchases Should Be Based On One’s Interest Rate Outlook
Making a case for municipals right now – especially for clients in the higher tax brackets – is actually pretty easy. This is because many higher quality municipal bonds are yielding more than benchmark Treasuries, a situation that has occurred only several times in the last two decades. Historically, munis have yielded about 90% of the rates paid on comparable governments. But due to the insurer crisis, investors can currently buy 10-year A rated munis yielding close to 4% or 40 basis points more than 10-year Treasuries. For clients in the higher tax brackets, the after-tax returns on munis can be substantially higher than nominal returns. Because income from municipal bonds is tax free, a 4% municipal bond yield equates to a 5.97% taxable return for someone in the 33% federal tax bracket. State tax and the alternative minimum tax may apply, which would reduce yields.
Having established that municipal bonds, as an investment, are attractive on an after-tax basis for clients in the higher tax brackets, the more challenging question, in our opinion, is what to buy. With the economy likely to slow further in the coming quarters in our view, most investors will likely want to stick with quality, ratings of A or better, although continued downgrades among the smaller insurers (to below investment grade) could lead to some unique opportunities for more aggressive total return investors.
The bigger dilemma facing municipal bond buyers now is the fact that closely-indexed Treasury yields are trading close to five-year lows. The Federal Reserve, in an effort to avoid a recession, is aggressively reducing short-term rates, making returns on shorter term munis less attractive. If history is any guide, flooding the economy with cheap money eventually may create an inflation problem and lead to higher interest rates.
Since prices on higher quality bonds generally move inversely with rates and long-term maturities generally are more volatile than short-term maturities, investors must be discriminate on new purchases. Clients who think the economy is headed for a protracted recession should consider buying more rate-sensitive, longer term issues.
Conversely, investors who agree with us that long term rates will likely bottom over the next quarter or two as the economy begins to stabilize should keep new purchases shorter (no more than 7 years) and consider staggering maturities. A common strategy used by portfolio managers when long-term rates are expected to rise, bond ladders allow investors to reduce their exposure to overall portfolio volatility (by keeping maturities shorter) and staying more current with changing market conditions (rolling over maturing proceeds according to a predetermined schedule).
In summary, the municipal market is likely to experience continued volatility in the coming weeks as the saga involving bond insurers plays out. The good news is creditworthiness of most issuers remains strong and further weakness in selected issues – especially insured AAA issues marked down to a stand-alone A ratings – offer com-pelling value for some investors in the higher tax brackets.
Given all the understandable confusion in the marketplace regarding credit quality and rate trends, we think it makes sense for clients to review their existing portfolio as well as future strategies with their JP Turner broker.
Although the information included in this report has been obtained from sources we believe to be reliable, we do not guarantee its accuracy or completeness. This report is for informational purposes only and not intended as an offer or solicitation to purchase or sell any securities. Sources used to compile this report include Bear Stearns, Bloomberg, bondmarkets.com, fidelity.com, investinginbonds.com, realmoney.com, USA Today, valubond.com and wikipedia.com. More complete information is available upon request. Yields and price information as of
2-8-08. Peter Conroy - Bond Trading Desk - JP Turner & Company LLC.
Compliance ID #JPT021208-092M