Kotok: Why You Should Buy Munis Now

July 31, 2013


IU.com: Let's talk about those 40,000, and how you parse that. Where do you see the opportunities?

Kotok: Forty-thousand issues probably consist of 95 percent of the total outstanding bonds. The other 50,000 are very small. So you can think about this as a universe of about $3.8 trillion that requires the research on the 40,000 separate issues.

Now, when you get into the tax-free municipal bond market, you need to be able to read bond indentures, understand municipal contracts, and examine trust and fund accounting, which are the government accounting rules under which these various 40,000 issuers operate. The good news about that is that it is a very transparent, high-integrity universe of information. The bad news is most people don’t have the skill sets to examine it in great detail.

IU.com: So where are the opportunities? You’re not looking at this through the lens of the ETF market, are you?

Kotok: We do not go into the ETF space very often in the municipal bond world, and we also don’t go into any mutual fund type of space in the municipal bond world. We like to do our own individual bond selection. And that’s the nature of our business now. We have the resources to do it, we manage billions in munis, and we've been doing it for 40 years.

IU.com: Right. So if you paint some broad brush strokes here and become a little more granular in terms of where the opportunities are, you seem to be saying that a lot of this concern is greatly overblown.

Kotok: It's a hugely overblown concern. It makes a great headline. This is where Meredith Whitney and I fully and completely disagree. We disagreed five years ago when she said there'll be hundreds of billions in default, and we disagree today.

Nearly all of the troubled credits are forecastable well in advance. If the bond buyer buys them, they are able to do so speculatively, but knowingly.

IU.com: So is all this even a legitimate thing to be worried about? And maybe more to the point, which seems to tie in to what you're telling me, does it even matter?

Kotok: Yes, it does matter because the pricing of bonds and the way they trade and the liquidity to support them is driven in part by headline risk. The reason it’s driven by headline risk is due to the mutual funds in collective holders. With a Whitney-type scare or a Detroit-type scare, every fund gets redemptions.

This means all of the fund managers face a dilemma. On any given day, they need cash to pay shareholders at the end of the day. They have to sell a bond to raise the cash. The bond that they would like to sell, the weakest credit, has been pounded down by the market. So the bond they are more likely to sell is the one they can sell quickly and raise the cash to meet the redemption. So they sell their highest-grade credit and depress its price in order to get the cash to pay the redemption.


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