January 5, 2010

Municipal Insecurities

With U.S. tax receipts down 19%, income tax collections down 28%, and sales tax revenues down 11% on a year-over-year basis as of June 30, 2009, according to a September 2009 newsletter from Breckinridge Capital Advisors, Inc., many investors are worried about the fiscal health of municipal issuers at the state and local levels.

Most states are now facing 2009-2010 budget deficits, since roughly 90% of each state's revenues are derived from income and sales taxes, while local municipalities primarily receive revenues from property taxes. Many states such as Michigan, California, New York and New Jersey are experiencing torrents of negative press due to fundamental weakening of their economies and fiscal situations, which has sparked fears of municipal bond downgrades and defaults.

Institutional asset managers in the municipal bond market are navigating this environment in a number of ways. Most have underweighted state General Obligation bonds of states with the direst fiscal conditions, in favor of states with healthier economies and more stable tax revenues (think of Texas, for example). In addition, many managers are focusing on local General Obligation bonds where the underlying demographics and tax base remain strong. Another area of interest for investors has been in Essential Service Revenue bonds (water, sewer, and electric), where the issuer typically has a de facto monopoly and the flexibility to raise rates to meet debt payments, if needed. Lastly, while investment managers are generally underweighting higher-risk states (California, Nevada, Florida, New York and Michigan come to mind), in those instances when new issues are priced at significant spreads to the rest of the market, they have been buying and in large amounts.

Between 2002 and 2007, roughly 50% of new municipal bond issuance came to market with insurance from AMBAC, FGIC, MBIA and other insurers, according to a report, "Municipal Market Update 2009," from Fidelity Investments. The number of issuers purchasing insurance quickly declined in 2008 amid the monoline insurance debacle and subsequent downgrading of the monoline companies' credit ratings. In fact, in 2007 there were seven insurers rated AAA by the three major rating agencies. Today none of the insurers are AAA-rated by all three major rating agencies (Moody's, Standard & Poor's and Fitch). Further, in 2009, less than 15% of new bonds have been insured, according to the Fidelity report.

The dramatic fallout in the insured municipal bond universe led to insured bonds trading on their underlying ratings, resulting in wide spread credit migration from AAA quality to AA, A and BBB ratings. Individual investors representing roughly half of the market, and many institutions, have long relied on the credit rating agencies and insurance-enhanced credits to build their municipal bond portfolios. Now, with the evaporation of the insurance industry and the growing distrust in the rating agencies, many investors have been exposed to greater credit risk than they had previously anticipated or experienced. In some instances, insured municipal bonds have traded at discounts to the exact same bond without insurance, which highlights the extreme headline risks and dislocations that have occurred in the municipal market over the last 24 months.

A number of professional asset managers are capitalizing on the situation and purchasing discounted insured bonds, as they know that it is technically impossible for insurance to decrease the quality of a bond beyond its underlying fundamentals. The large downward drift in credit ratings has not yet resulted in a large volume of violations of investment guidelines as set forth in mutual fund prospectuses. However, wealth managers should note that the change in credit ratings has resulted in greater volatility in municipal bond mutual fund net-asset-values and many investors are reassessing their risk tolerances accordingly.

All of this uncertainty has led to a less efficient municipal bond market where sound, fundamental credit research and credit surveillance are more important than ever. Now, opportunities are available for savvy investors who can identify mis-priced credits in the muni market; that is, to select those municipal bonds with relatively greater yields than are warranted by the fundamental credit qualities of the underlying issuers. As a result, institutional investors have been increasing their research efforts with deep analyses of current portfolio holdings and expanded coverage on lower quality issues. For instance, Breckinridge Capital Advisors Inc., has hired two new credit analysts to further bolster their research team in light of the market environment. In other shops, portfolio managers are asking more of their analysts to pick up the additional research responsibilities.

Given the current dynamics of the municipal bond market, today may be as good a time as ever for wealth managers to take a second look at the resources and processes applied to credit research at professional asset management firms. Take the time to ask your managers about the current positioning of their portfolios and how their approach to credit analysis and research may have changed as a result of a more complex municipal market. Money managers that make a concerted effort to adapt and work hard to find the diamonds in the rough may be the same names that you find at the top of the performance charts five years down the road.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital (www.primacapital.com), which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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