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GMS Special Report: The Municipal Bond Market is Under Valued

Wednesday, Oct 23, 2013

Over the past several years sensationalism created by misleading mainstream media headlines often resulted in unwarranted downward moves in the muni bond market. In the majority of cases these illconsidered market headlines would later prove to be frivolous. For the most part these major market disturbances were not due to traditional general fixed income market conditions or movements in interest rates. Since 2008 the major risk to municipal bond prices has been provocative headline risk. These unfounded or sensationalized news stories, articles and forecasts embraced by the media are commonly written or submitted by unqualified individuals, predominately non-participants in the muni market. Many sophisticated investors bought muni’s during these downward movements as the uninformed and misguided investor sold, many millions of dollars were lost many millions were made.

Investors are well aware that the fed forecasts the possibility short term interest rates may rise in mid2015. Some interest rate guru’s point to Japan, where interest rates have remained extremely low for the past 20 years, as they predict interest rates will remain low for the next decade.

Today when compared to taxable fixed income investments municipal bonds offer more than the traditional yield spread. Unbelievably in many sectors of the yield curve, tax free muni bonds are yielding more than taxable corporate bonds. For “High Net Worth” investors this extremely rare phenomenon presents an opportunity to cushion their portfolio against a future rise in interest rates. For the “High Net Worth” investor in the top tax bracket (43.4%) a tax exempt 5% return is equivalent to an 8.83% return on a taxable investment.

There are reasons for the tax free bond vs. taxable bond yield spread anomaly and also for why the municipal bond market has become so fragile:

  • The municipal bond market is a retail dominated market that overall is less liquid than equity markets and the corporate bond market.
  • Majority of individuals who invest in muni’s are buy and hold investors.
  • Even though the muni market is large, over $3.7 trillion in outstanding bonds, market activity is muted when compared to the stock market and corporate bond market.
  • Municipal bonds are bought for income and are not a traditional trading vehicle for individuals; therefore, the major brokerages do not focus on or emphasize the low spread, low profit retail municipal bond business.
  • Since most municipal bonds have a much more stable source of revenue than corporate bonds, the municipal market has less timely news, less complete research and less disclosure than the SEC registered corporate bond market.
  • Within a given year only 1% of all outstanding muni bonds trade which makes pricing inefficient. This vacuum allows unfounded forecasts and sensationalized media articles that scare investors to continue to surface without rebuttal.
  • The vast majority of individuals purchase municipal bonds from stockbrokers or financial consultants who for the most part are generalists not focused on municipal bonds. These financial generalists are also uninformed victims of sensationalized muni headlines.
  • The shortage of informed brokers and accurate information provoke investor and financial advisor fear. The lack of knowledge creates broker advised selling which strains market liquidity exacerbating price declines. A buying opportunity quickly becomes apparent to the sophisticated investor guided by a muni bond specialist.
  • As the market and prices eventually go back up and panic subsides the financial generalists advise clients who sold that it is once again safe to return to the muni market, albeit at higher prices.
  • Over the past several years sensationalized media headlines have focused on the risk in municipal bonds instead of the overall safety of the municipal bond market.
  • The most telling example of the safety of muni bonds; overall “Baa/BBB” rated municipal bonds have a better safety record than “Aaa/ AAA” corporate bonds (Baa/BBB municipals 99.63% vs. Aaa/AAA corporate bonds 99.48%).
  • It is extremely rare that an investment grade municipal bond defaults. History records that a “AAA” corporate bond is more likely to default then an essential service “BBB” municipal bond.
  • As previously mentioned, for the most part retail investors are directed by financial advisors at large brokerage firms. These brokerages and their financial advisors are generalists. In many instances they inadvertently influence markets by creating a herd mentality. Example: On 12/1/2010 Meredith Whitney on “60 Minutes” predicted a $100 billion municipal bond market default scenario, without investigating her irresponsible forecast of mass municipal bond defaults, the herd mentality of the large brokerages took shape and resulted in an across the board municipal bond “sell” advisory. The sell advisory created panic, the municipal bond market tumbled for no legitimate reason, informed investors bought at artificially depressed prices. The market eventually recovered; the uninformed sellers lost money.
  • Since Whitney’s irresponsible default forecast the default rate on municipal bonds has been the lowest in recent history. There are many such examples; California is bankrupt, Municipal bonds will become taxable, In Chapter 9 Bankruptcy individual investors will receive pennies on the dollar etc., etc. In all of these examples, astute investors capitalized on panic as uninformed or misguided bondholders sold at distressed prices and lost money.
  • The rating agencies assessments of municipal bond credits and their stable, predictable revenue streams are not comparable to their assessments and ratings on corporate bonds. Therefore, rating agencies do not provide a reliable benchmark for the usually lower credit risk associated with a municipal bond when compared to a similarly rated corporate bond.
  • The sensationalism and drama that exists when the media focuses on a politically mismanaged public entity that has outstanding municipal bonds usually signals a buying opportunity for the well informed. An essential service, municipal bond default that results in an individual investor permanently losing interest and principal payments even when the entity files for Chapter 9 bankruptcy is very rare.
  • Very few municipal bond investors have experienced a default on an investment grade essential service municipal bond.
  • Most investors don’t even know an individual who had an investment grade essential service municipal bond default.

“Insured” distressed municipal bonds offer unparalleled value

Today media sensationalism has once again created opportunity. The current municipal bond market offers unparalleled value in distressed municipal bonds that are insured as to the timely payment of interest and principal payments by the two largest financially strong bond insurers (Assured Guaranty and National Public Finance Guaranty).

The two major insurers will no longer insure municipal bonds issued by Detroit and its agencies or bonds issued by Puerto Rico and its agencies. However, the bonds they previously insured issued by Detroit and Puerto Rico must continue to be guaranteed by these insurers as to the timely payment of principal and interest. Both Assured Guaranty and National Pubic Finance Guaranty are financially sound insurers that Moody’s and S&P rates from mid to high investment grade. The ratings are based on their ability to meet all guarantees on all municipal bonds they have insured.

Insured bonds issued by Detroit and Puerto Rico can yield as high as 6% to 7% depending on maturity and the insurer. These yields for “High Net Worth” investors in the highest tax bracket (43.4%) are equivalent to receiving 10.63% to 12.41% on a taxable investment. Locking in fixed yields that beat historical stock market returns presents a rare opportunity for “High Net Worth” risk/reward investors.

Insured distressed municipal bonds are not suitable for everyone. However, for the informed “High Net Worth” investor that understands risk/reward insured distressed municipals may be worth investigating as to whether or not they are a suitable addition to the risk portion of their portfolio.