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Finding Value in Municipal Bonds

Municipal bonds lost 4.52% in the fourth quarter, a dramatic decline for fixed income assets, and have dropped an additional 2.49% in the first two weeks of 2011. 
The losses can partly be attributed to rising Treasury yields as well as a flood of new issuance related to the expiration of the Build America Bonds (BABs) program, which provided a subsidy for municipalities to issue tax-exempt bonds.  When BABs were not included in the tax-cut extension bill, issuers pulled forward deals planned for 2011 and significantly increased the supply of municipal bonds on the market.
Meanwhile, demand waned as fear took hold. The fear began after Meredith Whitney (a well-known analyst) called for 50 to 100 “significant” municipal bond defaults in 2011 totaling “hundreds of billions” of dollars. A default occurs when a borrower is unable to pay their debts on time. Headline risks also added to the fear, as the New Jersey Economic Development Authority had difficulties issuing bonds and Vanguard canceled plans to open three municipal bond index funds.
I personally worry about the effect of escalating fiscal strain at the state and government levels on the broader U.S. economy. I don’t see the level of defaults that Meredith Whitney is predicting, but I am concerned about the economic consequences of both higher taxes and reduced spending in municipalities. I also worry that the federal government might feel the need to support ailing municipalities at the expense of its own fiscal health.
All that said, it seems like the broad fear of the municipal bond market has unfairly beaten down the price of some municipal bonds that have little to do with the state or local governments. Revenue bonds of essential service providers are a good example. This includes debt issued by a city water, power, or sewer provider. These businesses generate stable revenues, face little competition, and have very little dependence on a municipality’s financial well-being. Other examples include bonds backed by school districts, airports, and mass transit.
Ultimately, navigating the huge municipal bond market comes down to picking the right types of investments. Acropolis evaluates a wide range of municipal bonds across different sectors and states. Obviously credit risk (risk of the issuer failing to repay its debts on time) is a factor, but just as important (if not more so) is duration.
Duration measures a bond’s change in price in response to a given change in interest rates. It is greatest source of risk and return in a fixed income investment. As interest rates rise, longer duration bonds will lose value faster than shorter duration bonds. Although longer duration bonds have higher yields, we currently favor duration between two to three years in today’s environment.
The fiscal problems for municipalities are very real, but like any other investment, negative headlines and forecasts may eventually create value opportunities for those that are looking in the right places.