Farr: There's Gold In Them Thar Munis!
We typically focus our market commentaries on discussions of topics that impact the equity markets.
A couple of things have happened over the past 2 years that have transformed the once boring fixed income market into something a bit more interesting. Today's market commentary will focus primarily on big changes that have occurred in the municipal bond market and how you might take advantage, on a very selective basis, of these dislocations when building conservative bond portfolios.
Let's start with a brief analogy. Imagine you're an investor with a million dollars to invest in bank CDs. However, the rules of the game state that only $100,000 may be invested in any one institution.
Pretty easy decision, right?
You would invest $100,000 in each of the ten highest-paying banks because the FDIC currently insures bank deposits up to $250,000. But now imagine that the rules of the game change such that there is no FDIC insurance. That would be a more challenging exercise to say the least. Instead of relying solely on the FDIC insurance to make investment decisions, the investor would have to perform credit analysis on each individual bank to ensure she will receive her money back (with interest). This would probably lead to a situation where smaller, less well-known banks would have to pay higher interest rates than their larger brethren in order to attract CD accounts.
This situation would likely exist, despite the fact that many of the smaller banks might be less risky than some of the larger banks, because investors would rather blindly put money with institutions that they know than to do their own credit analysis.
Something similar to this now exists in the municipal bond market.
Municipal bonds, issued by state and local governments, pay tax-free interest with many carrying insurance that guarantees timely payment of interest and principal. This insurance is issued by one of several major bond insurance companies, such as MBIA or Ambac.
Most of these insurance companies were rated AAA but, due to the mortgage meltdown and shoddy underwriting, they have either been severely downgraded or eliminated from the market. As a result, municipal bonds that were initially sold with AAA rated insurance but no underlying rating (issuers would have to pay the rating service for an underlying rating in addition to the premium payment for the insurance guarantee) now trade in the marketplace with only a downgraded insurance rating or no rating at all. These bonds offer conservative investors an attractive yield because most muni bond investors refuse to take the time to do their own credit analysis on an individual issue.
This dislocation in the municipal bond market has created an opportunity.
At Farr, Miller & Washington, we believe that carefully selected bonds of this type have excellent risk/return characteristics for investors looking for tax free income and a stable return on investment. For example, we recently saw a municipal bond issued by the American Red Cross. The organization issued taxable bonds in June 2007 with AAA rated Ambac insurance, but it did not apply for an underlying rating.
These eight-year bonds with a coupon rate of 5.56% traded at discount to par, an attractive yield premium over US Government and investment grade corporate offerings. Independent credit analysis estimates that The Red Cross would garner an investment grade rating if it did decide to pay one of the rating agencies for a rating.
In the tax exempt arena, we've seen attractive issues yielding 4% to 5% and in some cases even higher, and all federally tax free. That equates to a taxable equivalent yield of 6.15% to 7.7% for investors in the highest federal tax bracket. As an example, we saw a medium-term, tax-free municipal bond issued by a southern state that was financing local infrastructure projects. The bond is backed by a pool of loans to local borrowers, with the added security of an appropriation from the state if any of the local borrowers were to default on payments. This bond was originally insured and rated AAA. Now that the insurance rating is essentially meaningless, the bond trades as a non-rated bond yielding over 5% tax-free.
These types of opportunities don't come along all that often.
Most of our client bond portfolios will continue to be dominated by AAA and AA General Obligation or essential service Revenue bonds. However, we believe that these opportunities are welcome additions to a conservative bond portfolio from both a yield and a diversification standpoint, without compromising the overall safety of the portfolio. Individual investors will want to seek professional help and counsel before wading into the more arcane world of municipal credit research on their own.
However, many investment firms have excellent municipal research departments. Most regional firms have considerable credit expertise that is usually specific to their region of the country. Done properly, it may take some extra effort, but there's gold in them thar munis!
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Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.