More On Tax Planningfrom The Advisor's Professional Library
- Cafeteria Plans The income tax treatment of cafeteria plans is key to their popularity. Learn how to maximize the tax benefits of these “flexible benefit plans”.
- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
Boston-based research firm Aite Group has released a new report about municipal bonds which outlines the changes wrought on the muni market during the financial crisis.
“Things have changed dramatically,” says John Jay (left), senior analyst at Aite Group and author of a new report on the state of the states and municipalities that make up the municipal securities market in America. The report, “Municipal Bonds: Not Your Father’s Market,” is a primer on the basics and current trends of the municipal securities market. Jay discussed his findings in an interview with AdvisorOne.com on Wednesday.
Lack of AAA-rated Supply
“For municipal bond fund shareholders, there is a dearth of bond availability…[there are] no longer enough AAA-rated bonds,” Jay explains. Why? Because there are relatively few bonds that are rated AAA based on the creditworthiness of the underlying municipality or state—whether their tax revenues can cover the bond payments sufficiently. Munis have been a haven for investors, with tax exemptions and because the AAA-rated general obligation bonds of states, municipalities or towns were considered very safe since they had the power to raise taxes, if necessary, in order to pay off the bonds.
“The balance sheets of the municipalities or the states,” he says, have been hit very hard by the crisis, with unemployment, home valuations down and accompanying tax revenues diminished. Many more AAA-rated munis relied on bond insurance to get the AAA rating—insurance which covers a much lower fraction of the muni market now, according to the report.
Without the insured AAA-rated muni supply, Jay contends that muni bond funds that “promise an average of AA+ or better-rated bonds” in the portfolio are having trouble finding supply, and are “shrinking.” There’s a “big class of investor out there that looks to the tax exemption as an important part of the investment decision.”
Muni Bond Insurers Suffered Big Setbacks
The decrease in the issuance of insured municipal bonds is in large part a result of bond insurers’ respective forays away from insuring munis. Most of the muni insurers—referred to as monoline insurers—broadened their scope to insure structured products, many of which defaulted and cost them dearly during the financial crisis. In addition, portfolio managers discounted the value of such insurance during the crisis, preferring to value munis based on a municipality’s underlying balance sheet.
Monoline insurers like MBIA, AMBAC, FGIC ACA, FSA “have ceased to insure municipal issuances altogether” the report states, adding that Berkshire Hathaway Assurance Corp. insures a small portion of the munis that are issued with insurance, and Assured Guaranty “dominates” the market for insurance on muni bonds, “with roughly 90%” of the market. According to the report, about half of the munis issued in 2007 were insured, while in 2010 it’s down to about “8%.”
AMBAC in Default
AMBAC had a net loss of $57 million in the second quarter of 2010 versus a net loss in the 2009 second quarter of more than $2.3 billion.
AMBAC is widely reported to be considering bankruptcy; The Wall Street Journal reported Tuesday that AMBAC “said its board had voted to skip an interest payment on senior notes due in 2023. The payment was due to be made Monday; if the insurer hasn't paid in 30 days, it would be in default.”
Financing Costs Go Up for States and Towns
Not only did muni insurance allow for more AAA-rated supply for muni bond portfolios and mutual funds, but it helped lower the cost of financing for municipal projects for states and towns across the U.S. Infrastructure, hospitals, schools, dorms, and other obligations of states and towns, as well as some private projects or facilities—like sports stadiums and pollution control facilities—are financed via lower-interest-rate municipal securities.
The fact that munis have special tax treatment provided these projects or municipal/state obligations a way to cheaply finance their projects at rates significantly below what taxable bonds would cost. The higher the rating, the lower the interest rate, so without an underlying AAA or the insured AAA-rating for the bonds, the cost to taxpayers to pay off the bonds is higher. It “affects Mom and Pop,” both as taxpayers and investors, Jay asserts.
Don’t Try This at Home
Because of the specialized knowledge required to “figure out the underlying credit,” Jay is concerned about the “people without the luxury and benefit of an advisor.”
There is, he says, the potential for “do-it-yourself-investors” to harm themselves if they buy munis directly through the discount or online brokerage platforms without an expert advising them. It isn’t that the platforms are harmful—it’s the requirement of specialized knowledge and relative lack of information about individual bond issues, coupled with the idiosyncratic ways they sometimes trade that’s at issue for the do-it-yourself-municipal bond investor.
This is an area of investing where it is vitally important to get expert advice from a “trusted advisor that can act as a filter,” argues Jay. As an alternative, perhaps instead of buying individual bonds, they should consider buying munis via a mutual fund from a good fund company.
Jay concludes that the muni market is “very fractured. At the end of the day” he says, he expects “costs of municipal” issuance to rise.
The report can be purchased, here.
(This editor is a long-term shareholder of Berkshire Hathaway.)