Munis Poised to Fall Off a Cliff? Hardly...Here's How to Tell the Good From the Bad

 |  Includes: BAB, BCL, MUB
by: Eric Linser, CFA

Investors are, or soon will be, opening their year-end statements. If you had a good portion of your portfolio allocated to stocks, you most likely had a very good year. If you had a taxable account with a good amount of municipal bond holdings, you saw the value of those securities fall over the months of November and December. You may have still done OK, but losses are always a bit disconcerting. A chart of the iShares National Municipal (Muni) Bond Fund ETF (NYSE: MUB) shows a sharp sell-off in November and December.

For many income oriented investors, muni bonds (or bonds in general) help them sleep soundly at night. Lately they have been stirred from their slumber.

A rule of thumb for bond investors is that price and yield always move in opposite directions. When one goes up, the other goes down -- a teeter-totter, if you will. Understanding this is critical. All else being equal, longer maturity bonds have more pronounced effects to interest rates.

Investment securities are always in flux; nothing is constant in the financial markets. Prices change as investors respond to whatever is going on in the US or the world, especially if the news affects Wall Street's view on the future of interest rates. For muni bond investors, this also includes issues affecting their state or local governments.

What we are seeing now is a steepening of yields demanded for longer dated maturities, say 10 - 30 years out. A chart of the 10 year Treasury yield curve is here (by the way, 34 = 3.4%).The 10 year Treasury is a bellwether issue for the bond market’s outlook on the economy and inflation. From October’s low around 2.3% for the 10 year Treasury, you can see that yields have backed up to 3.4% and probably headed towards 4.2% as the year progresses.

We’ve seen a number of developments over the past couple of months that have weighed heavily on the municipal bond market. Though bond prices can and do fall on news specific to a state or municipality, they tend to move as a group in lockstep with interest rates, except in the opposite direction.

Current Concerns

In December, the media was all over the specter of looming defaults in municipal bonds creating a wave of panic sweeping over the bond market.

Default Risk in Perspective

Municipal bond issues aren’t as homogeneous as Treasury securities. There are more that 60,000 muni bond issuers and about a million different bonds. I am sure that some issuers will run into trouble but the overall number will remain small, say maybe a worst-case scenario of 100.

The fact is that most defaults we’ve witnessed over the past 30 years aren’t what I’d consider municipal debt at all. They are quasi-corporate bonds in the guise of some municipal conduit so the issuer could qualify for tax-free financing. Examples would include bonds for industrial park developments, housing developments, entertainment parks, co-generation power plants.

Historically muni default rates are less than 0.1%. In 2010, $2.5 billion of municipal bonds defaulted (in a $2.8 trillion market), compared with $14.5 billion of corporate bonds, according to the Distressed Debt Securities Newsletter. There were no defaults in 2010 by state or local governments rated by Moody’s rating agency.

What to Do?

If you hold municipal bonds as a tax shield and treat them as your “sleep well at night” money then stick with the highest rated issues. Like eggs, bonds are rated by quality. AAA-BBB are investment grade, BB-D are speculative grade or junk bonds (and D stand for default). Understand that if you purchase AAA rated bonds, or the best, you’ll pay a higher price, thus a lower yield, and you may not get the income flow you need from these bonds but credit quality won’t be a concern. Look for general obligation (GO) and revenue bonds that are first, rated by an agency like Moody’s, Fitch or S&P, and secondly, that have rating of “A” or better at the time of purchase.

Review the bond ratings and the maturities on your brokerage statement. If you hold bonds rated BBB or lower and/or have maturities that are longer than 12 years out, you may have unwanted volatility which would warrant a review of the security.

Additionally, if you don’t know anything about the municipality or the source of income required to repay the bond in which you are invested, you may want to get a second opinion on its “value.” Shy away from lower quality municipal bonds/funds. While you may earn 5-6% tax-free, you could very well lose more than that in principal value negating any positive inclination you originally had. If the yield on a muni bond or bond fund looks too good to be true, its creditworthiness should be considered suspect.

Is the State of California Going Under?

No, not at all. States can’t go bankrupt. There’s no printing press in Sacramento, occasionally IOU scrip. The state must constitutionally balance its budget (insert laughter) by making spending cuts and/or enhancing revenue through taxes, fees, or the like. Bond debt servicing has the second highest priority behind education funding for the state.

For fiscal year 2011, California’s general fund revenue should be approximately $89 billion (same as it was in 2009). Of that, $36 billion is earmarked for education which leaves $53 billion to service $6.6 billion in debt interest and principal payments (up from $5.1 billion in 2009). The state has plenty of money to pay its debts on time, and for now, debt service is a relatively small portion of most state budgets.

Federal, state and local governments have masked the lack of revenue receipts to cover their excessive spending by taking on more debt. Municipalities are now stuck with big debt loads and property tax revenues that have been severely strained. With 26 new governors just now taking office, politicians are getting the message – balance the books! Our elected officials need to make hard decisions. It’s an arduous undertaking but the sooner we get underway, the sooner we can build a more solid base for future economic shocks that are sure to occur.

Though the high-profile budget crisis in California leaves a somewhat distorted impression of state and local government finances, sound credit analysis is more crucial than ever during these turbulent economic times. I believe that risk management is critical in any investment program, and with any fixed-income investment – including municipal bonds – one needs to consider a variety of risk factors, including credit, liquidity, interest rate, concentration and even headline risk.

Other Bonds to Consider

No investment is completely risk free not even US Treasuries. Take for example a 2 year Treasury yielding 0.6% (nominal yield). If inflation is 2%, then you’re (real) yield is negative 1.4%. The key is to look at individual securities and your overall investments in totality as a balance between risk and return.

While I believe one should steer clear of Treasury bonds, you can’t make such a blanket statement with munis. There are opportunities within municipal bonds. Outside of state GO bonds, look to what I call essential revenue bonds – water, gas, electric, sewage and the like. In a large metropolitan area there are a sufficient number of payers to keep the creditworthiness of that particular issuer fairly attractive.

You may be able to garner better results in other segments of the bond market. Consider high quality domestic and foreign corporate bonds and possibly an allocation to a junk bond fund. Consider foreign government bonds including emerging markets, but steer clear of troubled European nations. An allocation to these bond asset classes can offer diversification, lower risk, and potentially higher returns, even though they are not tax-exempt like most municipal bonds. Consider the placement of these bonds in tax-deferred or tax-free accounts such as traditional or Roth IRAs.

Tough Road Ahead

As I’ve discussed in the past (my July 29, 2009 article California’s IOUs = We Owe More), the state’s not in great shape. Misery loves company and there are many states right there with us – Illinois, New Jersey, and New York, to name just a few, have onerous financial quandaries at their respective state level. Many states were already stretched going into the recession and that made them all that more vulnerable to ongoing economic headwinds.

Some industry experts view California's troubles as a buying opportunity, believing that California bonds might be attractive enough for investors to jump in. I would say that if we are truly committed to making structural reform -- balancing revenue and spending and putting money aside in good years for rainy days, then I believe the state’s long term viability could translate into an opportunity to buy California munis at attractive levels.

Sure there will be an increase in the number of municipalities that have to shore up their finances but the municipal market is not poised to fall off a cliff. Interest rates are going up and bond prices will adjust accordingly. While there will be defaults in the municipal bond market as in the corporate bond market, I would caution against painting all muni bonds with the same broad brush and exiting the market based on all the doom and gloom in the media. Get a balanced perspective and work with a financial advisor who has the credit research available to discern which muni bonds are best for your risk tolerance and income needs.

(Click here to see California State Treasurer’s current credit ratings and comparison to other state’s general obligation bond ratings.)

Disclosure: I purchase and hold various municipal bonds for my clients and own some personally.