'Sleep at Night' Investments, Part Three: Single General Obligation Municipal Bonds

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Includes: MUB
by: Five Plus Investor

Don McClean crooned in the old 1971 song “American Pie” about the “day the music died”.

Was this then the “day the municipal bond died”?

For several months after this “60 Minutes” interview aired on December 19, 2010, message boards were ablaze with debate. Was our country on the verge of yet another great financial crisis – rampant municipality defaults?

The debate has died down as the municipal bond market recovered. Clearly, municipal bonds were not the place to be between November 2010 and mid-January 2011, as shown with the municipal bond ETF (NYSEARCA:MUB):

However, since January the municipal bond market has rebounded. What happened to the billions of dollars of defaults that were supposed to materialize as early as this spring? In spite of all of Ms. Whitney’s crooning about the death of the municipal bond, it just didn’t happen. Spring came and went with no major news of rampant municipal defaults.

Now “our blonde friend" (as Bloomberg’s Pim Fox recently called her) is back-peddling and denying. On an interview with Tom Keene of Bloomberg radio she states “I never said that there would be hundreds of billions of defaults. It was never a precise estimate over a specific period of time.” If you watched the video above, you know that’s exactly what she did say.

Default Risk in Perspective

This is not to say that default risk with municipal bonds doesn’t exist. It’s just that “our blonde friend” overstated it. There are over 55,000 municipal bond issues outstanding. In any given year, there are probably 50 to 100 defaults. So in a typical worst case scenario of 100 defaults, this equated to about a .33% yearly default rate – 1/3 of 1%. Even if Ms. Whitney’s crystal ball was accurate, and the default rate doubled or tripled this year, that is worst case a 1.33% yearly default rate.

Municipal Bonds – A Timeless Safe Haven

The very first U.S. municipal bond was issued in 1812 in New York City. It was a general obligation bond and was consider trail-blazing in its time. Nearly 200 years later municipal bonds can still serve as a “Sleep at Night” investment for many income investors.

If you want to learn more about municipal bonds, Fidelity has an excellent primer on the types of municipal bonds and features, benefits and risks associated with owning them. I recommend this primer, as well as the following:

Introducing: General Obligation Municipal Bonds

Instead of detailing every type of municipal bond, this article focuses on the one type that most bond experts are recommending now: the general obligation bond.

A general obligation (“GO”) municipal (“muni”) bond is a bond issued by a municipality which is secured by a state or local government’s pledge to repay the bond holders through legally available resources, primarily tax revenues. In other words, a general obligation bond is backed by the taxing power of the issuer.

If you believe that the most certain things in life are death and taxes, you will want to own a general obligation municipal bond!

Advantages of GO Muni Bonds

As stated previously, the primary advantage of holding a GO muni bond, as opposed to revenue or other type of municipals, is the taxing power of the issuer. Other general advantages of owning municipal bonds:

  • Tax-Exempt Income: This is the most well-known advantage. The income from a municipal bond is generally exempt from federal taxes, and if you hold a muni bond from your home state it is free of state / local taxes.
  • Credit Ratings: After the financial crisis in 2008, the main credit ratings agencies (Moody’s, Standard & Poor's & Fitch) performed a broad reassessment of bond ratings in all sectors. As a result, most analysts believe that since 2009 the ratings system has become both more stringent and reliable.
    Interestingly, while muni bonds also came under scrutiny, it was the one sector where the scales were actually changed (“recalibrated”) so that the prior rating scales had overstated the default risk. Simply put, munis came out of this review with more “flying colors” than other bond sectors.
  • Insurance: There are many bonds which are backed by insurance which guarantees the interest payment and principal in case of a municipality default.
  • Sinking funds: Many states issue bonds that are backed by “Mandatory Sinking Funds”. A sinking fund is simply a pool of money set aside by the state or municipality to service the interest and principal of its debt.
Risks and Considerations for GO Muni Bonds

Every “sleep at night” investment has risks and considerations, including GO muni bonds. Before investing it is good to ask these questions:

  • Economic health of locale, region and state: Is the GO muni bond from areas where population is stable or growing, with a broad tax base that includes some stable or growing industries?
  • Source of revenue: Does the bond have only one, or many, sources of revenue?
  • Municipality managers / councils: Does the municipality or state have a good track record of fiscal responsibility?
  • Protections for bond holders: What are the rate covenants? Are there reserve funds to service the debt? Is the bond insured?
  • Call Risk: What are the call provisions? Am I buying my municipal bond near a call date? Am I buying under the call price?
  • Credit and Default Risk: Am I buying a bond that is considered “investment grade” and has little risk of default?
The Greatest Risk: Interest Rate Increases

Most investors feel comfortable buying bond within funds, either open-ended (mutual funds) or closed-ended (CEFs), as opposed to purchasing single bonds. The bond market may scare off many retail investors simply because they are more familiar with the mechanics of the stock market.

But is the more familiar solution the right one at this time?

To answer this question we need to address a fundamental risk to general obligation (“GO”) municipal bonds (“munis”) and bonds in general: Interest Rate Risk.

There are two types of interest rates attached to fixed income instruments – variable and fixed. A variable rate bond adjusts for a rising interest rate environment; a fixed rate has a fixed coupon rate, and does not. The effect of rising interest rates is that the price and value of the bond declines. An excellent explanation of this dynamic can be found on Fidelity’s “Prices, Rates and Yields” page.

If your primary concern is growing capital, the prospect of rising interest rates means bonds appear on the surface not to be your kind of investment.

If your primary concern is income, you will likely not care what happens to the capital anyway.

But what if you have both capital preservation and income as goals? Do you eliminate bonds altogether because of the risk rising interest rates present to your capital base?

To discover the right answer, you need to ask the right question. The right question is not – are bonds a good investment? The right question to ask is:

How do I exit my bond investment?
Funds Vs. Single Bonds: Winning the Interest Rate Risk Debate

Did you answer the question I just posed? If not, I’ll answer it for you:

  • Funds – to exit you must sell.
  • Single Bonds – to exit you have the option to sell or hold on to maturity.

Most funds, both open- and closed-end, maintain a “constant maturity”. There is no date at which the entire portfolio matures and capital is returned to the investor. This factor, coupled with rising interest rates, inevitably leads to lower Net Asset Values (NAVs) and lower share prices for funds. There is also the risk that as the NAV decreases, fund managers will decide that a distribution cut or elimination is in order to preserve their particular fund.

The only way out of this spiral downward on a fund is to sell it. Selling your fund in a rising interest rate environment may well mean you lose a substantial amount of your capital investment. Not ideal.

With a single bond, you have a choice – sell on the secondary market, or hold to maturity. In truth, single bonds will suffer the same fate as funds in terms of deflation with rising interest rates. But the choice to hold on to maturity provides us with the “sleep at night” advantage:

In a rising interest rate environment, your bond investment capital is preserved with single bonds held to maturity.

No matter how much your single bond deflates, you are paid back your investment in full upon a call or upon maturity. This means there is no depletion of capital, as long as you bought under or at par. If you buy well, you may even make a profit when you bond is called or matures.

Getting Ready for the Buy

If you are now convinced that the best place for bond exposure is single bonds (specifically GO muni bonds), you now must consider the following before you buy:

  • New or Secondary Issue
  • Ratings
  • What you Want: Insurance, Sinking Fund
  • What you Don’t Want: AMT, State Taxes, Long Maturity Dates
New or Secondary Issue

The first issue to consider is which bond market to participate in: new issue or secondary.

New issue means you participate in an initial bond offering – the equivalent of an IPO for stocks. In terms of fees, this is a cheaper way to invest, as many brokerages waive the “concession” or brokerage fee on new issues. This provides a cost savings, but you are buying the bonds typically “at par” or the call price.

Once investors begin to sell their bonds, they go on to the secondary market and are subject to market prices. Buying a bond on the secondary market means paying the concession fee which can be substantial (about $1.00 per $100 bond). However, buying on the secondary market is the only way to buy at a discount to call price.

For both new and secondary issues, you need to be aware that a minimum investment is considered $5,000. You purchase your bonds in lots of $1,000, and in most cases a minimum number of lots for purchase is five (5) lots.

Ratings

Once you decide between new and secondary issue, you must consider the rating of the bond. The ratings agencies have made it easy to choose the “sleep at night” bond: just stick with Investment Grade rated bonds. Blaha.net provides an excellent summation of credit ratings and what they mean. In a nutshell, you want a rating of Baa and above with Moody’s, and BBB and above with S&P, Fitch and Duff & Phelps.

What you Want: Sinking Fund and Insurance

These two advantages were explained previously. You will want to own GO muni bonds that are backed by insurance and a sinking fund.

Municipal bond insurers have lately come under scrutiny, and as such you will want to own a bond from a relatively health insurer. WM Financial Strategies provides a good table on the outcome of recent reviews. The result:

  • AMBAC – Caa2 (negative) but on review for possible upgrade
  • Assured Guaranty Municipal Corp (FSA) – mixed; S&P gives a positive AA+ rating; Moody’s gives Aa3 rating with negative outlook
  • CIFG – Rating Withdrawn (negative)
  • FGIC – Rating Withdrawn (negative)
  • MBIA – Baa1 with developing outlook

Assured Guaranty and MBIA, of the major insurers, appear to be the strongest. There are a whole host of smaller insurers for which you may need to conduct due diligence for the bond you are considering.

As for the sinking fund, it is always best to hold a GO muni with this additional safeguard.

What You Don’t Want: AMT, State Taxes and Long Maturity Dates

The Alternative Minimum Tax is typically not an issue with municipal bonds, but if you want to be safe you should always input “No” for AMT on any bond screener.

For those living in states that impose a state income tax, you can forego paying this tax on bonds that originate from your home state. Those who live in states which do not impose a state income tax are free to own muni bonds from any state, without state income taxes incurred.

As for maturity, most bond experts are recommending a cut-off on maturity date of within the next 12 years, or to 2023.

Putting It All Together

We are now ready to screen for potential choices that fit the criteria for a high yield investor. Since many of us may have state sales tax to consider, it is best to venture outside your brokerage screener, as I have found most provide minimal screening choices.

MunicipalBonds.com appears to have an excellent screener for state-specific bonds. You will need to register to access all the features of this site. Scottrade also provides a fairly robust screener for a brokerage house, and provides hard copies of Moody’s reports with bonds that qualify.

For the fun of it, I conducted a municipal bond screen in my Scottrade and Fidelity brokerage accounts. Since muni bonds provide tax-free income we can set the yield lower to 3.65%, roughly the taxable equivalent of 5% yield. I set the criteria at:

  • General Obligation
  • 3.65% Coupon
  • 3.65% yield or more
  • Under Call Price
  • Insured
  • Moody’s Report available
  • Moody’s rated Baa1 or better
  • No AMT
  • Recent Moody’s Commentary 2010
  • No Recent Moody’s Downgrades
  • Overall Positive Report

What the screen quickly revealed is that most bonds meeting our yield criteria originate from the highest profile troubled state – California. (For simplicity’s sake California State GO bonds are left out. For all its fiscal woes California State GO bonds are still considered investment grade, and many meet our screen criteria). Our screen also includes many long bonds which unfortunately do not meet our 12 year cut-off for maturity.

Issuer

State
CUSIP
Moody
Rating
Coupon
Yield
Sinking
Fund?
Price
Now
Call /
Maturity
Bolingbrook Village

IL

097552NK5

Aa3

4.75
5.186

Yes

$93.75

01-2015 01-2038

Town of Milford

MA

599496QC3

Aa2

4.25
4.612

Yes

$94.597

12-2017

12-2036

Kirtland Local S.D.

OH

497692DW0

Aa2

4.50

4.805

Yes

$95.833

06-2016

12-2033

(FL) City of Hollywood

FL

436146DA9

Aa2

4.25

4.39

No

$98.32

06-2015

06-2028

NW Harris Co. MUD #5

TX

667488HL7

Aa2

4.00

4.129

Yes

$98.64

11-2014

05-2025

Norht Sacramento
School Dist.

CA

662078CQ5

Aa3

5.00

5.061

Yes

$99.25

06-2011

08-2030

Puerto Rico

PR

74514LRA7

A3

4.75

4.762

Yes

$99.89

06-2011

07-2023

Click to enlarge

As you can see there are precious few choices which pass the brokerage screen. Only one bond – the last one from Puerto Rico – meets our standard for maturity.

I would therefore strongly recommend using MunicipalBonds.com for screening in addition to your brokerage screener.

Best Buys Right Now

There is an argument to be made that bonds in general are not a buy right now. However, for certain investors there is never a wrong time to invest in a single municipal bond. The recommendations below are tailored to various types of investors’ goals:

  • Retirees – Since your focus is solely on generating income right now there is little downside to owning insured investment grade GO municipal bonds of your choosing, even superior grade long bonds. You must determine to hold whatever bonds you purchase to full maturity. New issue bonds may work well for you. Set your goals and choose wisely.
  • Income Investors – There is little downside to owning GO munis right now, but you may not want to get locked into a long maturity. Both new issues and secondaries will work for you. Look for investment grade GO munis that mature no later than 2023.
  • Blended Approach – Many of us are currently in funds, and there is no point in selling them – yet. However, I would get out before an interest rate hike is announced. While stocks are still preferable to bonds for appreciation, there may be little downside to holding a small stake (5% or less) in single GO munis maturing before 2023. Secondary issues provide the best value. You may want to consider a higher stake (more than 5%) if you are closer to retirement.
“Maturity” – the date at which the bond is called and the capital investment is returned to the debtor – is at the heart of whether bond funds or single bonds will win the interest rate risk debate.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: Five Plus Investor is written for the retail investor, from a retail investor’s experience and point of view. The articles presented by the author are for informational purposes only. Five Plus Investor is not a professional investment counselor. Before investing one should conduct their own due diligence or seek the advice of a professional as needed.