Fixed Income Strategy - Municipal Bonds

With investors seeking yield in this low rate environment and the expectations for tax rates to increase, we are often asked about municipal bonds (muni’s). Historically, retail investors purchased very long maturity muni’s because they offered an attractive after-tax yield in a relatively safe investment.

Changes in the market dynamics today make investing in muni’s a more difficult task. It used to be that investors would just look at the rating and make certain that it was not subject to AMT. After all, we have all been told before that muni’s have a very, very low historical default rate and therefore they bear little credit risk. However, the same was said about real estate until 2007. In today’s environment, one must really dissect a bond based on the four primary risk factors of all bonds: credit risk, term/duration, structure, and liquidity.

Credit
Historically, most muni’s came to market with very high ratings with many qualifying for the coveted AAA. The vast majority of AAA rated bonds achieved this status because an insurance wrapper was purchased for most issues.

When a muni is insured, the insurance company guarantees the timely payment of principal, so the muni assumes the same rating as the insurance company. This process allowed poorly rated issuers to issue AAA rated debt. In early 2008, the financial stability of the insurance companies came into question and nearly all of them lost their AAA rating. As a result, many muni’s were severely downgraded. The downgrade was not a direct reflection of the credit quality of the issuer, but a result of the insurance being downgraded.

Regardless, the investor who purchased an insured AAA-rated muni is now left with a lower rated muni (or in some cases, non-rated). The downgrading of a vast number of bonds that were previously rated AAA has adversely affected market prices of the entire muni market and lowered the liquidity of many issues.

Today, investors must perform a thorough analysis of each municipal issue. It must be assumed that the insurance attached to each deal is worthless and one must evaluate each issuer’s ability to service their debt on its on merits. After all, if the issuer can service the debt, then the fate of the insurance wrapper is irrelevant.

Term
The maturity of a bond affects your exposure to changing interest rates and inflation. If you expect rates to decrease, it makes sense to purchase longer maturity bonds to lock in the higher rate. The opposite is true as well. When an investor expects rates to rise, shorter term bonds are a better investment as they will depreciate less and the shorter maturity will grant the investor the opportunity to reinvest at higher rates in the future.

The traditional retail investor has always purchased longer maturity municipals. By purchasing bonds in the 10-20 year maturity range, the investor is able to achieve a higher yield. There is no free lunch, as the higher yield is simply a trade-off for a higher level of market risk. With today’s rates at historic low yields and potential for inflation, we do not think that it makes sense to extend maturities very far into the future.

Structure
Structure refers to the timing of cash flows along with any optionality that is embedded into a bond. Muni’s are typically straightforward bonds that pay interest on a set interval and pay back principal at maturity. However, many muni’s also have embedded call options that give the issuer the opportunity to retire the bond prior to maturity. Since the bond will only be called if it is advantageous for the issuer to do so, calls typically work against the investor. This is referred to as optionality since the issuer has the option to call the bond.

The structure will also affect the liquidity and market price of an issue, so one must fully understand the structure of the bond they are purchasing. Many older outstanding bonds have call dates that are very close or are even callable today on a continual basis. If an investor does not know about this feature and only looks at Yield to Maturity or Current Yield, they could earn significantly less than expected (or even lose money) if the bond is called away early. An investor must understand the structure and always evaluate a bond based on a Yield to Worst scenario.

Liquidity
Liquidity is defined as the ability to buy and sell a bond. If a bond is very liquid, there will be an efficient market and the bond can be purchased or sold quickly with a minimal bid-offer spread (low transaction costs). Unfortunately, the municipal market has historically been a rather illiquid market. This is one reason that muni’s have provided above market yields as investors must be compensated for the loss of liquidity. In the muni market, it is common for there to be a wide price difference between where you can buy a bond and where you can sell it.

Beginning very early in 2008, liquidity in all markets became a hot topic. Certain types of muni’s enjoy ample liquidity, however, many have nearly no liquidity at all. The maturity, credit, structure, and even block size all contribute to the ability to buy and sell a particular issue. These criteria have always been the same, but were often overlooked leaving investors holding bonds that they would have difficulty selling today if needed.

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The current market inefficiencies do provide opportunities in certain sectors of the municipal market. However, they are not for everyone. An investor must be able to separate the good from the bad to determine value. Muni’s remain exposed to credit risk, are less liquid than many other forms of fixed income, and may not be the best relative value for all investors. For example, depending upon your marginal tax rates, you may be able to realize a higher after-tax return in taxable bonds versus tax-free muni’s.

With all of the new spending coming out of Washington, the muni market is only going to become bigger and more complex. A new category of muni’s was just created: Build America Bonds (BABs). These are bonds that support infrastructure projects, but will often be subject to income taxes.

Protecting your assets begins with understanding all of the underlying risks. The next step is to have the tools to evaluate them and determine the true relative value before investing.


Ryan Craft, CFA
Senior Fixed Income Analyst