From the August 2010 issue of Research Magazine • Subscribe!

Have Munis Lost their Mojo?

Assessing the safety of the muni market.

It's no secret that cities, states and counties across the U.S. are in dire straits. Budget deficits are up, tax revenues are down. What lies ahead for the $2.8 trillion municipal bond market? Are massive widespread defaults of municipal bond issuers in the cards? And how can advisors help their clients to play this ever growing dangerous market?

Before we can ascertain the future of the municipal bond market, knowing its history can add some perspective.

Since 1839, there have been fewer than 10,000 investment grade municipal bond defaults out of over 1 million issues. Almost half of these occurred between 1929 and 1937, in the Great Depression era. A widely cited study by Professor George H. Hempel indicates the majority of defaults that occurred during the Depression era were cured within a few years.

Municipal defaults peaked at $2.85 billion in 1933 and began falling rapidly in 1934 and 1935. By 1939 municipal defaults had declined to approximately $200 million. The Hempel report states that loss of principal and interest from defaults during the Depression period averaged 0.5 percent of state and local debt.

Despite the high recovery percentage, many munis investors were forced to sell and suffered considerable losses during this period. Ron Ryan, CEO of Ryan ALM observes that important differences in fiscal and debt management have evolved since the Depression era. "States and local governments have adopted conservative debt limits, stronger tax enforcement, improved financial reporting and higher oversight of local governments," says Ryan. Despite fiscal turmoil, he notes that investment grade municipal bond defaults have become a rarity.

Changing Dynamics

Warren Buffett cut his firm's municipal bond holdings to under $4 billion during the first quarter of this year from almost $5 billion in 2008. In public statements made to the Financial Crisis Inquiry Commission, Buffett voiced concern about the ability of municipalities to pay for the retiree benefits of public workers. He seemed perplexed on how to properly ascertain the credit risk of muni bonds and he made the suggestion that a future federal bailout of strapped cities and states could be next.

Still, there's a world of difference between budget-strapped local governments and bankruptcy.

According to data from Municipal Market Advisors, there's $6.3 billion, or less than 0.2 percent of the current muni bond market, presently in default. "Only 14 carried a major credit agency's bond rating at the time of default, and more than half of the total dollar amount in default ($3.8 billion) is attributable to a single issuer -- Jefferson County, Alabama," notes Rob Williams, director of income planning at the Schwab Center for Financial Research in a recent report.

Got Insurance?

One of the more unsettling developments within the municipal bond market has been a lack of insurance. This is perhaps one of the clearest signals that things in the muni bond market aren't the same as before. Not only is the cost of insuring against muni bond defaults escalating but the availability of insurance is scarce. Two years ago, more than 50 percent of municipal bonds were protected with insurance against default. Today, just one active bond insurer remains (Assured Guaranty). The Bond Buyer estimates less than 10 percent of new munibonds issued last year came with bond insurance.

Compounding the concern has been the trustworthiness or lack thereof for the credit ratings assigned to municipal bonds. Over the past few years, credit rating agencies have become a punching bag for misrating billions of dollars in debt.

"It is important to keep in mind that these regrettable lapses of judgment by the rating agencies in the past were related to the ratings of mortgage-backed securities, not municipal bonds," states Ryan. Unlike with complex debt instruments, he argues, rating the creditworthiness of municipal bonds is a fairly straightforward process.

The analysis of a revenue bond focuses on calculating the strength of the revenue stream from a particular project or facility, in comparison to the costs associated with operating the facility. It's the role of rating agencies to project these factors into the future based on reasonable economic assumptions. Likewise, the creditworthiness of a general obligation municipal bond is determined by evaluating an existing tax base, along with the dependability of tax collections in that issuing entity.

The ultimate lesson of bond ratings is this: look at them, but don't rely on them.

Muni Tips

Look at segments within the muni bond market that may help you to reduce your client's risk. For instance, Van Eck manages a pre-refunded muni bond ETF (PRB) thath may carry lower risk versus conventional munis.

Pre-refunded muni bonds are created when municipal issuers refinance outstanding debt to take advantage of lower interest rates and reduce their financing costs. They accomplish this by issuing so-called refunding bonds whose proceeds are used to buy securities that are placed in escrow and dedicated to paying the interest and principal on the original issue, which then becomes "pre-refunded."

These bonds derive their high credit quality from the escrowed securities that secure them. In general, those securities consist solely of obligations directly issued or unconditionally guaranteed by the U.S. government, specifically, U.S. Treasury bonds as well as State and Local Government Series bonds, or SLGs, a type of Treasury security issued specifically for escrow use by municipal issuers. Therefore, the portfolio is diversified, but unlike other municipal bond funds, PRB takes on no issuer (credit) risk related to individual states or municipalities.

How else can advisors help their clients to maneuver around the potholes?

Here are a few new rules of thumb when it comes to muni bond investing:

  • Get and stay diversified. Try to avoid holding individual muni bonds in client portfolios and help your clients to understand the credit risk associated with certain bonds may be undermining the tax benefits. "Diversification is, and will always remain, important in portfolio management," states Christopher Alwine, principal and head of Vanguard municipal bond fund operations. "Investors will need to balance the tax advantages of a state specific fund with their lower diversification. Diversifying a portfolio by investing in both a national and a state specific bond fund is one way to achieve that balance."
  • Know your limitations. Most advisors aren't qualified to handle in-depth credit analysis of individual bonds. And even if you are, do you really have the time to closely monitor credit quality? National muni bond ETFs like the iShares S&P National Municipal Bond Fund (MUB) and the SPDR Nuveen Barclays Capital Municipal Bond ETF (TFI) offer broad exposure to a portfolio of various municipalities and states throughout the country.
  • Seize opportunities. Imbalances within the muni bond market may cause yields to rise to attractive levels. This is especially true when the market has overestimated risk. Instead of running for the exits, put on your contrarian cap and help your clients to identify opportunities as they manifest themselves.
  • When in doubt, go insured. One strategy is to stick with a portfolio of insured muni bonds. Instead of needing to identify which bonds are insured versus which aren't, one can rely on ETFs that do all the work. For example, InvescoPowerShares offers three insured muni bond ETFs: the PowerShares Insured California Municipal Bond Portfolio (PWZ), PowerShares Insured California Municipal Bond Portfolio (PZT) and the PowerShares Insured National Municipal Bond Portfolio (PZA).
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