Boiling Point: Sifting Through Muni Carnage

January 25, 2011

Finding gems in the muni market wreckage.

It’s now been about three months since the municipal carnage began. Dire predictions by media-hungry analysts have renewed fears of potential widespread defaults, and the recent talk of a bankruptcy option for states, highlighted by the New York Times, has added fuel to the fire.

Chadd BennettThe result has been record outflows of municipal mutual funds and a backup in yields that, in my view, has created many buying opportunities in select names.

One of the major problems I have with all the media coverage is the emphasis on default. As I’ll go into a bit later, most research shows, over time, higher-quality credits return 100 percent of their principal, even if they miss payments and need to restructure at some point.

If there’s a bigger “systemic” issue, it lies with the subsequent tax hikes and/or the cuts in social services as state and local governments seek to balance their budgets. The ripple effects and social backlash throughout the country certainly will not improve risk appetite or general optimism.

Understanding Market Structure

The bigger reason to be opportunistic has to do with how the municipal bond market is structured. More than two-thirds of the roughly $3 trillion muni market is held by individual investors and mutual funds.

As mutual funds receive redemptions, they typically need to raise cash by selling individual securities into what is mostly an illiquid market. This forced selling is essentially what leaves good credits at undeserving discounts. But you need to know what you are looking for.

While spreads on munis have widened considerably on concerns about the financial health of cities, counties and even states, rising benchmark yields also contributed to the 10 percent pullback in the iShares S&P National Municipal Bond Fund (NYSEArca: MUB). That’s pretty much all the ETF’s gains last year.

Since the end of September, the 10- and 30-year Treasury yields have risen by 36 and 24 percent, respectively. For illustration purposes, look below at the iShares Barclays 20+ Year Treasury Bond ETF (NYSEArca: TLT) (in red) compared to the iShares S&P National Municipal Bond Fund (NYSEArca: MUB) (in blue) to see how much the sell-off in Treasurys has contributed to the correction in municipals.

 

TLT Performance for 2010

 

Finding Opportunities

It’s important to remember that in any bond purchase, investors are simply lending an entity money for a set period of time. The terms under which that’s done relative to the compensation you receive is crucial. Does it have any property liens? Where is its cash flow coming from? Every bond has different caveats, so it’s important to read the fine print and discuss with a fixed-income specialist prior to any decision.

Fitch Ratings breaks it down into six different classes in terms of recovery rates in the event of the dreaded default. The safest class—Class 1—includes state general obligations (GO) bonds as well as sales-tax-backed debt. That’s followed by Class 2 and 3, which contain local GOs and essential services such as water, sewer, public power distribution, airports, etc. According to Fitch, you can assume that these top 3 classes will recover 100 percent of par should they default.

While missed coupon payments and the time value of money are factors that also deserve consideration, this should give some perspective to the real risk of certain municipal debts.

The bottom line here is that after considering your individual tax status, risk appetite and the usual investment parameters, there is opportunity in municipals. But stay focused on high quality by targeting bonds with good ratings that are backed by taxing power and essential services.


Chadd Bennett is a trader and former financial advisor specializing in fixed income. He worked at Bear Stearns when it collapsed, then joined Morgan Stanley Smith Barney.

 

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