23 November 2009, Financial Advisor

Not so long ago, municipal bonds were considered the “belt and suspender” kind of investment that offered steady, tax-free returns with low volatility and virtually no risk.

But a perfect storm struck municipal bonds (climaxing toward the end of 2008), that continues to reverberate in today’s market. Its impact has prompted investor to doubt the ability of local, county and state budget officials to deliver on their tax-based bonds. And much of the same uncertainty has clouded convictions about various revenue-based municipals as well, including those supported by water, sewage, power, dormitory and industrial development authorities.

Turbulence came to a head as a severe bear market and recession drastically cut into government tax collections, challenging already precariously balanced budgets. Governments continue to commit more resources to restart growth and provide relief for an expanding number of unemployed. This sent the need for government borrowing soaring while credit markets were seizing up.

But at the core of this crisis was deteriorating credit qualities of a half a dozen monoline insurers, including MBIA, AMBAC and XL Capital Assurance, who were collectively insuring up to half of all outstanding municipal bonds just several years ago. By mid-2008, these companies were no longer considered viable financial backstops for missed payments, says Geoffrey Schechter, manager of the MFS Municipal High Income Fund. He surmises that no more than 10% of all new issuances carry bond insurance, and the Assured Guarantee Corporation is the only significant municipal bond insurer remaining.

Such insurance, which had produced AAA-ratings, sent demand for municipals soaring by various asset managers and funds who were borrowing short, at fractional rates, and investing long in municipals with supposedly guaranteed payments that were several times higher.

As monoline bond insurers were being downgraded, so too were many municipals’ AAA ratings that they supported. This subsequently forced highly leveraged carry traders to unwind fast, flooding the market with unwanted bonds. Ebbing investor demand couldn’t absorb this oversupply, sending prices drastically lower and yields higher. Sudden;y, some investment-grade bonds had suddenly lost up to half their values, according to Schechter.

There were also doubts about the integrity of rating agency evaluations of corporate and subprime instruments. These doubts spilled over into the municipal arena, when a former chief compliance officer at Moody’s Investors Service recently offered congressional testimony that his firm did virtually no follow-up “surveillance” on its municipal bond ratings after they were initially made, despite Moody’s claims to the contrary.

This further intensified the global flight to quality from the fourth quarter of last year through the first quarter of this year, sending investors scurrying into Treasurys and pushing their yields lower.

The result: Traditional spreads between Treasurys (which normally pay more) and municipals (which normally pay less because of greater tax advantage) inverted. At one point, investors were actually receiving up to 300 basis points more for AAA-rated triple-tax-free municipal bonds over state and local tax-free Treasurys of equivalent maturities.

Recovery

The muni market recovered significantly over the spring and summer. As of mid-October, according to Konstantine Mallas, portfolio manager of T. Rowe Price’s Summit Municipal Income Fund, weekly net inflows into munis soared from an average of $250 million to well over $1 billion over the past two quarters. This has helped yields to draw down to nearly even with Treasurys. But that ratio still suggests concerns about the health of municipals and the market environment in general, as demand remains strong for Treasurys. Mallas says 30-year Treasurys traditionally yield about 11% more than municipals to make up for their less-favorable tax treatment.

The Obama administration’s introduction of taxable municipal bonds has helped relieve market distress for munis. Known as Build America Bonds (BAB), this federal program has not only enabled governments to access a larger, more liquid and globally accessible debt market, but has provided a significant subsidy in the process. The national government is paying 35% of these bonds’ interest. In the third quarter, more than half of new long-term municipal issuances were BAB.

The interest subsidy more than makes up for the higher taxable yields issuers have to pay on the taxable market. According to Schechter, a 30-year highly rated BAB issuance yields around 6.40%. With the subsidy, the issuer’s out-of-pocket expense is 4.15%, or about 50 basis points lower than tax-free municipal bond yields.

The federal government’s involvement, however, doesn’t improve the safety of these bonds. “One must still perform the same due diligence in buying BABs as one would do for any other municipal,” explains Mallas.

However, a number of money managers saw value in these new bonds. “Initial uncertainty that tends to accompany most new types of offerings resulted in BABs being lower priced, offering above average yields for equivalently-r
Ated taxable bonds,” rcalls Robert DiMella, coportfolio manager of the $235 million MainStay Tax Free Bond Fund. “And since their initial offering in March, these yield spreads have shrunk, generating double-digit price gains on these bonds.”

Transparency

In the past, because default was generally regarded as highly unlikely with municipal debt, advisors may have thought little beyond the issuer’s credit profile and what the bond was rated.

Greater market uncertainty has changed that perception. Investors are finding that researching municipals is more challenging than they ever surmised because of problems of timely disclosure and transparency as well as due to the increased complexity of many issues. Unlike corporate bonds, whose complete financials are released no more than six weeks after the end of each quarter, there is limited uniformity to the information provided by the 50,000-odd issuers of municipal bonds. Most tax-backed general obligations report only once a year, with audited financials released no earlier than six months after the fiscal year closes.

Reporting is better with specific activity revenue-based obligors who often provide quarterly data, observes Mitchell Savader, a municipal bond expert. But he adds that “these statements often vary in terms of breadth and detail, limiting the ability to contrast risk and value among bonds.”

This is one of the reasons why, after working for more than a decade at a credit rating agency, Savader set up his own niche advisory firm in 2004. Savader Assets Advisors tracks about $6 billion in municipal bonds for various institutional clients, ranging from financial advisors to bond mutual funds, including INVESCO Aim and First Investors.

Though delays and deficiencies in municipal financial reporting limit certain analysis, Savader’s custom reports help investors get a clearer picture of risk that municipal disclosure fails to address. He provides an overview and analysis of the particular type of municipal bond being tracked—general obligation versus revenue-backed industrial, educational or health-related issues. He then generates a financial profile of the issuer, along with a review of its management, debt position, the reporting transparency and the conditions and prospects of the local economy.

“The rating agencies generally do an adequate job in assessing a bond issue when it comes to market,” says Savader, “but investors have little to go on after this initial review.” Investors would not buy a corporate bond based on analysis done several years before. But without a dedicated research team, most municipal bond investors are doing just that, basing their decisions on historically low default rates and current valuations, rather than on the systemic risks.

“If we’ve learned anything from the financial crisis,” says Tim Heaney, manager of the closed-end DTF Tax-Free Income Fund, “it’s that no institution is too large to fail and nothing is impossible.”

Heaney is less sanguine than many other observers who think that recent market stability reflects that largely fear had hit municipals. He sees many rainy day funds exhausted, one-off value coming from the federal government’s stimulus package, and uncertainty surrounding political resolve to make additional budget cuts and tax increases to assure the servicing of municipal debt.

“The fundamentals of municipal credit are being challenged in the most basic ways affecting revenue, property and income taxes,” says Heaney. With the municipal market a lagging indicator of economic trends, he fears that risks could increase if the U.S. economy falters and the federal government doesn’t provide additional relief.

In this scenario, bond prices could retreat again. But a rise in default risk would likely be seen in the less understood corners of the market, which is somewhat akin to the mortgage-related debt market where investors really didn’t understand the securities and their underlying risks.

Savader believes that we could see a tenfold increase in the historically modest rate of default, which is normally 10 to 20 issues a year, because of the greater complexity of familiar-sounding state and local issues that are actually backed by third parties with untested revenue streams.

These include specialized revenue bonds backed by troubled real estate development, not-for-profit hospitals, and universities that are financially overextended with limited recourse. “Investors may not be completely clear that when a private entity issues debt through a municipal name, it is this issuer, not the umbrella authority or government, who is solely responsible for this debt,” says Savader. And managers may find that this exposure is canceling out much of the risk control they thought they were securing by simply diversifying investments across different states.

Opportunity

While risk has increased, so has the opportunity to lock in remarkable yields and capital gains on depressed bonds.

David Fare, co-portfolio manager of Legg Mason Partners Managed Municipal Fund, turned over half of his $4.8 billion portfolio in the past year because he felt market dislocation offered a rare opportunity. “When everyone was ducking and running for cover in ultrasafe securities,” Fare explains, “we were able to sell pre-refunded bonds [debt that has been refinanced at rates below the original coupon with proceeds set in escrow until the bonds can be called] at a high price and convert proceeds into cheaper and higher-yielding munis that investors were avoiding, such as revenue-backed water, sewer, transportation, housing, hospital, power and education bonds.” Like many fund managers, he’s been overweight revenue bonds because their risk-return profiles have been more desirable than general obligation tax-backed bonds.

MFS’ High-Income Fund manager Geoffrey Schechter has done the same. Over the past year, he has added to his holdings of a New York City Industrial Development Authority Bond that raised funds for American Airlines operations at Kennedy International Airport, collateralized by the airline’s gates at JFK. This “B-” rated bond, due in 2025, is not for the faint of heart. It’s eye-popping triple tax-free coupon of 7 5/8 percent (though partially exposed to the alternative minimum tax), is 300 basis points more than AAA-rated municipals. After dropping below 80 in August, it had rallied back to 98 as of mid-October.

To Schechter, the bond’s underlying security is in the inelastic demand for gates at the country’s largest international airport hub. But Konstantine Mallas is wary of such high-risk asset-backed securities, saying that collateral claims, especially in bankruptcy, are rarely clear cut.

With an exclusive focus on investment-grade municipals, Mallas recently picked up an “A-” rated, 30-Year New York State Dormitory Authority bond at 96 7/8, yielding 5.37%. That’s about 110 basis points higher than a triple-A-rated municipal. The bond is backed by the Mount Sinai School of Medicine, and Mallas believes that in addition to the school’s stable finances, the prestige of this teaching hospital and its endowments suggest a significant degree of safety.

MainStay’s Robert DiMella has found special opportunity on the edge of investment-grade issues that the market may not fully understand. He points to his two percent exposure to the Newark, New Jersey Housing Authority Bonds due in 2038 that came to market with a tax-free coupon of 6.75 percent.

Despite the bonds being insured by Assured Guaranty, a AA-rated firm, MainStay gives the underlying debt a BBB rating because of the city’s economic weakness. But its research unearthed another compelling feature: the bonds are a binding general obligation of Newark, which means the city can levy taxes to ensure the debt is sufficiently serviced.

Because of the coupon’s high yield, DiMella also believes these bonds stand a good chance of getting pre refunded, which would basically assure all interest payments and redemption of the bonds at par upon the first call date. “If that happens,” says DiMella, “it would likely send the bonds soaring from their present price of $111 to more than $120.”

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