IU.com: Are you saying that these general anxieties about problems in different cities and states are legitimate to the extent there is a series of sort of extra-contractual deals getting done in different places, but at the same time they're all quite distinct, and that to generalize too much is off the mark?
Kotok: Well, I think what's needed is detailed research to understand the issues. And then, an investor needs to select well and avoid trouble.
IU.com: Tell me in laymen’s terms what the opportunity is in the municipal bond market in the context of the Fed possibly normalizing interest rates.
Kotok: Right now today, the very-highest-grade, true AAA tax-free bond trades in the United States at a yield higher than the taxable Treasury bond today.
IU.com: And that’s a generalization across the country even though each issue and each tax-free status often is linked to residents of each particular state?
Kotok: That is correct. Tax-free yields around the United States are pretty much at or above the taxable yields when they should be substantially below. So if you're a bond investor and you say, “I don’t want to own Treasurys, I don’t want to own a 3.6 percent 30-year Treasury bond, but I do want to have some bonds,” you can own a tax-free bond at a higher yield than the taxable Treasury, and built into that holding is the benefit of a future normalization between tax free and taxable. So you have a cushion in the tax-free bond that you do not have in the Treasury security.
And in fact, we now see some crossover buyers, pensions, people who don’t pay taxes, foreigners who are now buying the tax-free bond instead of the taxable Treasury because they can obtain that cushion to help them protect themselves as Treasury interest rates rise.
IU.com: You're talking the cushion from capital losses, essentially, or what?
Kotok: Well, a cushion against a price decline, as interest rates rise. If interest rates don’t rise, then the normalization gives you a capital gain in the tax-free bond. And if interest rates fall, you get the benefit of that fall just as you would with the Treasurys, so that essentially what the tax-free bond gives you is a better structure in a bond than a Treasury bond. And you do it without having to take on a great deal of credit risk.
The history of true AAA natural credit in the United States is zero default, just like the Treasurys.
IU.com: And going back to Meredith Whitney, you don’t expect that to change very substantially, all this concern about a blowing up of muni market?
Kotok: No, I don't. I mean, look, it makes a great media map, to put up a map and show 10 cities, with Detroit the latest, that are going through municipal reorganizations and bankruptcies. And there will be more of them. But you don’t see the map of the hundreds and hundreds of cities and credits that are paying every single day, meeting all of their terms.
So my view, this is a great sector. It’s $3.8 trillion. You need to look under the hood and do the work. You can't have it gifted to you for nothing. And you can take great advantage of it because it’s dysfunctionally priced. You may not like