Kotok: Why You Should Buy Munis Now

July 31, 2013

Never mind Meredith Whitney, there are great opportunities in the municipal bond market, David Kotok says.


David Kotok, chief investment officer of Cumberland Advisors, is looking right past the Detroit bankruptcy and Meredith Whitney’s warning about the dangers of municipal bonds and sees tremendous opportunities in the muni market. With total assets under management of more than $2 billion, the firm casts a long shadow.

Kotok, one of the most established ETF-focused financial advisors in the world, expresses his view on munis by owning individual bonds, steering clear of pooled vehicles such as ETFs to find the value himself. And with yields on tax-free munis higher than equivalent Treasurys, Kotok told IndexUniverse that the $3.7 trillion muni market is large enough and varied enough to avoid town, cities, counties and states that are in decent financial shape.


IndexUniverse.com: Let’s talk about the muni market. What do you make of Detroit and Meredith Whitney’s notion from her piece in the Financial Times that she sees a lot of Detroits that could pop up out of nowhere?

Kotok: First on Detroit, Detroit was predictable. The rating agencies have been downgrading Detroit for the last dozen years. There was a time in which a little over a decade ago that rating agencies had Detroit rated single-A credit. You could have tracked the credit changes by Moody’s, Standard & Poor’s and Fitch and watched it deteriorate to the quality of junk, and now junk default.

So anybody who bought Detroit bonds watching deteriorating credit and chasing higher yield now faces this issue of perhaps getting 20 or 30 cents on the dollar. And some judge, after a long process and lots of appeals, will determine who’s going to get paid how much.

IU.com: You're saying that it’s relatively contained? The broader context of the question, as I'm sure you grasped, is you have Stockton, California; San Jose, California; all these cities—that aren’t necessarily associated with the auto industry, but perhaps all having these pension obligations that suggest that this muni challenge is not confined to Detroit?

Kotok: The argument that all cities are bad, I disagree with. The argument that all municipal bonds are bad I disagree with. I've always maintained that this is an idiosyncratic market. There are over 90,000 issuers of tax-free bonds. Some of them are very small towns and the buyer of the bond is a single local bank. And some of them are very large, like the state of California.

So, there are about 40,000 issues that trade sufficiently deep enough to have reporting in databases. And they are not alike. Homogeneity in the municipal bond market is a falsehood. So you have to deal with 50 states and the territories like Puerto Rico, and you have to deal with counties and cities and structures that are different.

IU.com: So of the 90,000 muni issues, 40,000 of them are investable, and that’s the universe you look at?

Kotok: Correct.


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.


Kotok (cont’d.): We see this coming; we lower our bids in price substantially, and we watch the distressed seller forced to sell to people like us.

And so for our clients, we obtain great bargains. You cannot do that in the ETF mutual fund space. You can only do it in separately managed accounts. That’s why we don’t go into the ETF mutual fund space when it comes to munis.

IU.com: What about what Detroit is doing with possibly mixing general obligation bonds and revenue bonds? Is that something to be concerned about?

Kotok: Well, what the emergency manager is trying to do in Detroit is two things. No. 1, he's trying to lump all types of bonds into one pot and say they're all unsecured credits and we'll treat them all alike. There's a long history of a priority of liens, a first mortgage versus a second mortgage, a senior lien versus a junior lien. Bonds were sold, descriptions were made, documents were prepared, official statements were made public on these various structures.

The emergency manager's trying to throw all that out. Whether a judge will permit him to do it is a separate question; we're going to find out. But the fact that it’s been proposed is a shock to the muni market because the muni market operated for decades under the assumption that if you had a first lien, you had a senior claim relative to a second lien. And the emergency manager in Detroit’s trying to change the rules after the checker game started. That's the metaphor for what's attempted now.

IU.com: And are you suggesting he doesn't have a chance to get away with this?

Kotok: I don't know. Now, once you're into the realm of a judge having to arbitrate differing claims and there's an appeals process and you're in a legal system and the legal system is Michigan law, you're into a new area. And what the emergency manager is doing with the Detroit proposal is causing bond buyers to alter their assessment of risk on everything in Michigan because if he succeeds, then something else in Michigan is now suspect because of a change in legal structure.

IU.com: Now, this goes beyond Detroit and Michigan, and to places like California.

Kotok: Yes. I was going to get to that. We have a number of cities in California that are using California legal structures and bankruptcy to reorganize themselves. Now, this fight in California is unresolved. When it's resolved, it will be resolved by judges and courts and a legal process. Therefore, there's a risk profile in California today.

Illinois is a different state. It’s the state poster child for the weakest credit in the United States. It doesn't fund its pension obligations. The legislature is at a political stalemate. The amount of unfunded liability grows, and we see this constant debate in Illinois, and it, therefore, is carrying the weakest of the state credit ratings. And there are good reasons behind that.


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 Detroit, but you might like Salt Lake City. You may not like Illinois, but the Utah AAA state general obligation fund is one of the rock-solid strongest credits in the United States.



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