The once staid municipal bond market has received a lot of negative press lately. The states face unprecedented budget shortfalls. Stimulus money awarded to states during the financial crisis is starting to dry up. The Great Recession of 2008 pushed tax revenues down significantly. Politicians are loathe to cut expenses. State pension obligations look especially onerous after a decade of poor U.S. equity returns. Talk of Congress possibly changing the rules to allow states to file for bankruptcywas cited in a NY Times article earlier this week.
What does all of this mean for municipal bond investors?
It means a couple of things. First, it probably isn’t a great time to own a municipal bond index or mutual fund. These types of funds will very likely have significant exposure to states that are not in good shape. Why? Because the states that issue the most debt are usually in the worst financial shape, and more debt likely means a higher representation in a bond index or mutual fund!
Second, it means that performing credit analysis on each and every bond issue in your portfolio has become more important than ever. The municipal bond market is not a homogenous market. There are good states and there are bad states. Good states are in good fiscal shape. Good states are growing and attracting businesses. Bad states are in terrible fiscal shape. Bad states are typically not growing, and have heavy pension costs, and cash flow has been crushed by the recession or because of the downfall of a once- important industry. Though there are exceptions (e.g. it is possible to find good credits within bad states) Farr, Miller & Washington focuses most of its attention and credit analysis on bonds in “good” states. Bonds that are used to fund essential services (e.g. water, sewer, infrastructure spending, healthcare, education, etc.) are typically favored. Detailed credit analysis is then performed on each issue. Debt levels, cash flow levels, interest coverage ratios, specific project details, and local demographic and political trends are all examined.
So what is this detailed credit analysis turning up?
In short, the negative press has created many buying opportunities. Roughly $25 billion has flowed out of mutual funds that manage municipal bonds in the last few months. Investors appear to be selling municipal bonds in an indiscriminate fashion. Farr, Miller & Washington is buying A- and AA- rated, medium term, municipal bonds with good credit profiles in attractive states. From a credit standpoint, and subject to our research process, these bonds appear to us to be safer than equivalently rated corporate bonds. Historically, highly rated municipal bonds have been significantly safer than highly rated corporate bonds. These bonds are yielding, on average, two full-percentage points higher than an equivalently rated corporate bond on a tax-adjusted basis. Though two percentage points of yield might not sound like much, consider that we are currently operating in a world where the yield on the 10- year Treasury is 3.4%!
What are the primary risks to our strategy when it comes to municipal bonds? First, more bad news could certainly lead to further municipal bond mutual fund withdrawals. This could lead to more indiscriminate selling and push the prices of some of our existing bonds down. Since we typically plan to hold these bonds to maturity, price fluctuations don’t matter too much to us. The only thing that matters to a long-term holder is whether or not the municipality is going to pay its interest and principal in full and in a timely manner. Bad news out of CA may cause a water and sewer bond in Alabama to move down in price, but it should not ultimately impact the ability of that bond to pay us in full. Second, the municipal bond market is not as liquid as the Treasury bond market. We can always sell these bonds and sell them quickly if we have to. However, we might not get the best price for a bond that we have to sell quickly.
In summary, high quality taxable and tax-exempt medium term municipal bonds, if carefully chosen by an experienced, conservative bond manager, appear to be an attractive alternative to other bond categories. Please don’t rush into any investment without sufficient research and a thorough understanding of the risks you may be assuming.
On Tuesday February 8, I am flattered to join Dr. Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, and former Senator Don Nickles, R from Oklahoma at the annual Economic Outlook at the University of Delaware. Jon Hilsenrath from The Wall Street Journal will moderate a discussion of the Economic, Political, and Market landscape for 2011. It should be a great, informative discussion. Subscribers and CNBC readers are invited free of charge, but attendance is near full.
Please reserve your spot by emailing: email@example.com
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.