With budgetary problems at the state and local levels, municipal bonds have become an asset class everyone loves to hate; it’s tough to remember that just a few years ago many investors considered them second only to Treasuries in terms of safety. But Guy Benstead, co-manager of Forward Long/Short Credit Analysis [FLSRX] argues that municipal bonds aren’t the problem children of the fixed-income universe--they’re just misunderstood.
What’s your take on the municipal-bond market?
The municipal market has undergone the tumultuous transition from a unitary asset class to one that’s fragmented by credit-specific issues. This shift has occurred because the fundamentals of many municipalities are under stress.
This fear and uncertainty, though unsettling for many investors, furnishes us with ample opportunities.
Have the new Build America Bonds [BAB] been a game changer?
They have been a game changer for the marketplace, though they haven’t changed our strategy. For example, if we do a credit analysis of AMR Corp (NYSE: AMR), Texas Utilities or Dominion Resources (NYSE: D) and conclude that the credit quality and outlook are favorable, we’ll examine a variety of issues--from corporate and municipal bonds to trust-preferred securities--and add the cheapest and most attractive security to the portfolio.
Our approach to BABs doesn’t differ. We treat a California general obligation (CalGO) BAB just as we would a tax-exempt CalGO bond. Relative value is the key--that is, is it cheaper to own a taxable BAB than a tax-exempt municipal bond?
In terms of the market, BABs have changed the game by reducing the net supply of tax-exempt issues. The BAB market has gone from zero to $190 billion in about 18 months, and this issuance has primarily been in the long end of the curve.
We’ve seen an almost 1-for-1 reduction in new issues of tax-exempt bonds as BABs increase in popularity, a game-changing scenario that the market has yet to appreciate fully.
But once we turn the page on this year, and especially in 2012 and 2013, investors will realize that tax rates are taking a bigger bite out of their investment returns; demand for tax-exempt income will increase.
This confluence of factors will come to a head.
Baby boomers are looking to retire, and the bear markets of 2007 and 2008 took a lot of wealth out of people’s pockets and reduced risk appetites; fixed-income securities will attract a great deal of interest.
When investors compare returns at the new, higher tax rates, municipals and other tax-exempt fare will stand out.
But now credit quality is a major concern among fearful investors. All too often analysis stops at highlighting broader risks and why municipal bonds are a bad bet in this environment. Granted, some concerns are valid; budget deficits and lower revenues are a major challenge, though certain areas are worse off than others.
You believe many of the concerns are overblown?
Municipalities have been much more resilient than many investors expected.
A year ago fear predominated, and people tend to take the most recent experience and extrapolate it out on a straight line.
Many assumed that municipal revenues would decline 20 percent a year for the next six years, making bankruptcy a real concern.
But municipal revenues appear to have troughed as stock markets have recovered, and unemployment, though still elevated, has stabilized. Conditions may not be ideal, but at least things have stopped getting worse.
Unlike the federal government, the vast majority of state and local entities must balance their budgets each year, and many have found creative ways to cut spending.
These reductions may involve a bit of kicking the can further down the road, but expenditures have declined. Such decisions are difficult and unpopular. Nevertheless, managers, mayors and councils around the country are rationalizing municipal budgets and meeting targets.
We expect it will take at least another year or two for municipalities to get their fiscal houses in order. Some areas will succumb to the pressure and tip over, but anything approaching a universal default by municipalities is a long shot; the problems won’t be as widespread as many fear.
Many investors regard long bonds as a sucker’s bet because of the steep yield curve and uncertainty about interest rates. But nobody wants to sit on money that’s earning nothing, so they’re piling into shorter-term bonds and pushing down the yields.
We have no problem going out on the long end of the yield curve; we can hedge against the risk that interest rates will go up.
What are some of the opportunities you've found in this market?
CCC-rated Texas Utilities has its problems, but we own a municipal bond that’s puttable in 2011 and yields 9.8 percent, which, on a tax-adjusted basis, amounts to almost 15 percent. We picked the issue up at a discount, but we expect it to survive and continue to service its debt through the end of 2011.
Tobacco-settlement bonds also offer opportunities.
When tobacco manufacturers settled with states in the 1980s, these remunerations took the form of long-dated payments to each states that filed suit.
The biggest obligors were the old Phillip Morris, RJ Reynolds and Lorillard (NYSE: LO); together these firms accounted for 85 percent of the payments made to the states.
Instead of waiting for this money to come in, some states bundled portions of the payments into asset backed securities. Three of the biggest issuers are California, New Jersey and Ohio.
Ohio’s tobacco-settlement bonds are issued under the name “Buckeye Tobacco.” We hold a BBB-rated Buckeye with an active sinking fund; each year the issuer buys back a portion of the bond at par, leaving it with an average life of about 10 years.
Today these bonds trade at 83.5, and every 12 months some bonds are called. If you buy a bond at 83.5, you’re going to make 16.5 points on whatever portion is called. In the meantime, you still receive your coupon.
Because you’ll lose some of your bonds to the sinking fund, the issue has a 10-year average life and a tax-exempt yield of 7.35 percent. Let’s say you pay a tax rate of 40 percent; that’s a pretax equivalent of roughly 12.25 percent.
The three tobacco companies all have corporate bonds outstanding, and I’ll bet dollars to doughnuts that some of your readers own them.
For example, Lorillard’s 10-year bonds trade at 102.25 and yield 6.55 percent; Phillip Morris/Altria (NYSE: MO) bonds go for 127.5 and yield 5.4 percent; and an RJ Reynolds bond yields 4.75 percent at a price of 114. You could assemble a portfolio of these taxable bonds and get a yield of 5.5 to 6 percent.
Or you can buy Buckeye Tobacco bonds that are almost 200 basis points cheaper.
Here’s another opportunity in the misunderstood municipal market. Municipal Electric Authority of Georgia (MEAG) issued BABs earlier this year that are essentially credits of Georgia Power, which is part of Southern Company (NYSE: SO).
Georgia Power’s 30-year bonds yield 5.15 percent, while the MEAG BAB offers a yield of 6.75 percent— and these are essentially the same credit.
Another option is a state of California general-obligation bond. You can buy CalGO tax-exempt bonds with a 10-year maturity that yield 4.2 percent.
You might dismiss this yield as a bit low even though it works out to an after-tax equivalent of about 7 percent. But 10-year bonds issued by California-based grocer Safeway (NYSE: SWY) yield only 3.95 percent.
And if economic conditions deteriorate to the point that California is at risk of default, Safeway, which depends on the state’s citizens for 30 to 50 percent of its revenue, will also suffer.
Needless to say, municipal bonds aren’t grossly overvalued, especially on a relative basis.
What’s your best advice for investors?
The US economic recovery will be slow; we advise investors to add income-producing assets. In a slow growth environment, securities that pay you to wait are an attractive option. The low yields that prevail these days suggest that the market concurs.
We also believe in the municipal story I outlined earlier. Tax rates are headed higher, while the supply of tax-exempt bonds continues to decline. Long-dated municipal bonds are cheap right now, but once people get their tax bills in 2011 and 2012, tax-exempt options will be in high demand.
Don’t be shy about taking advantage of this market dislocation; the opportunity is clearly there, but it’s universally misreported in the popular press.
Disclosure: No positions