The municipal bond market will likely see more volatility in 2011, and there may well be municipalities that default in the year ahead.
Still, Goldman Sachs says high net worth investors should look beyond negative headlines and put cash to work now in high-rated municipal debt.
“Munis are trading at the same yield levels as treasuries on a pre-tax basis,” says Sharmin Mossavar-Rhamani, Chief Investment Officer for Goldman Sachs' Private Wealth Management Group.
“For clients who have a one to two year horizon, they will be looking at pretty attractive returns.”
Bond yields rise when the price of the security falls. Municipal bond yields rose sharply at year's end, pushed by a massive wave of selling. Municipal bond funds saw nearly $35 billion in outflows, over fears cash-strapped states and municipalities could be at risk of default.
“What we had was a real feedback loop,” says Citigroup municipal bond analyst George Friedlander.
“A weaker market causing bond outflows, and credit fears being reinforced by a market eroding very sharply.”
The municipal bond market began to weaken in the fall, with the rise in interest rates and a heavy supply of debt issuance ahead of the year-end expiration of the Build America Bonds program.
"Whatever you buy, be prepared to hold it to maturity, so that liquidity doesn't matter."
When analyst Meredith Whitney declared on “60 Minutes” that the market could face 50 to 100 “sizable defaults” in late December, the market turned extremely bearish.
Default Fears Overblown
Veteran municipal bond analysts say Whitney’s prediction of a major wave of defaults is fundamentally flawed.
“There is a massive difference between a budget crisis and a credit crisis,” Citi’s Friedlander explains.
“States are making severe cutbacks in spending for the first time in 30 years. There will be cutbacks that really hurt, but that’s not the same as a bond default.”
Citi is advising clients to invest in high-quality rated bonds, in part because pension funds and insurers attracted by high yields have begun to invest in those types of munis, providing stability to the market.
Goldman’s Sharmin Massavar-Rahmani also believes high-quality, agency-rated munis pose the least risk. (Watch Bertha Coombs' video interview with Massavar-Rahmani here.)
"There is a whole other universe," she explains, "20-30 percent of the muni market that is not rated.”
“We tell our clients not to be in those areas and let experts, people who know how to manage muni securities and do nothing but do credit analysis all day, invest those assets.”
Muni Strategy: Funds
Municipal bonds traditionally offer lower yields than U.S. Treasurys, because their gains are tax-exempt.
In high tax states like New York and California, a muni yield at par with a Treasury bond will effectively provide higher returns because investors can save on federal, state and local taxes depending on the bond.
“You want to take maximum advantage of your tax-exempt status,“ Mossavar-Rahmani advises. But she says residents can still reap federal tax benefits from out of state bonds.
“If you're in a place like Florida you can look at a more national profile for a mutual fund.”
In general, Goldman advises its high net worth clients to invest in funds of high-rated munis rather than individual bonds.
“We think a small allocation in the high yield municipal sector is quite attractive," Goldman's Mossavar-Rahmani advises. "Our expected returns in that space are 6-8 percent on an after-tax basis.”
Morningstar and Lipper rate muni mutual funds and ETFs, which can be bought in the same way as most securities.
Individual Muni Bonds
Investors interested in purchasing municipal bonds directly will need to go through a broker.
Once again, look for bonds that are rated, with a dedicated source of funding say strategists.
“The most rock solid is the essential service revenue bond,” says Jack Ablin, Harris Private Bank's Chief Investment Officer.
Bonds used by cities and towns to fund construction of projects like toll roads, and water and sewer systems are at low risk of default.
“In many respects it’s like a little business, “Ablin explains. “Its interest payments are directly tied to the fees they collect.”
The Muni Curve: Long Vs Short Maturities
While pre-tax yields at the long end of the muni curve now rival those of treasuries, Goldman’s Mossavar-Rahmani and Harris’ Ablin both advise muni investors to stick with shorter-term bonds.
“I wouldn't buy too far out because of the uncertainty and inflation pressures,” says Ablin. “I wouldn't buy any bond for more than 7-8 years.”
By contrast, Citi’s George Friedlander has been recommending 15-20 year maturities, which he thinks are an attractive value now.
“Because of the steepness of the yield curve, I’m not sure why one would want to stay short.”
Goldman’s Mossavar-Rahmani says one good reason is the outlook for the economy.
“While we like the yields, we don't like clients to go out that far, just because we think the economy is going to recover, “ she says.
“While those rates are attractive relative to short rates today, and relative to where we have been in the last three years, in five years time they won't look as attractive.”
Next Market Test: March Issuance
Since the new year, bond outflows have steadily diminished leaving the muni market relatively stable.
But analysts say issuance of new bonds has also been relatively light.
The market’s resilience could face a real test next month, when issuance is expected to pick up.
Harris’ Jack Ablin says more than the threat of default, muni investors now are more likely to get hurt by another buyer's strike if fear again sends investors to the sidelines.
"Whatever you buy, be prepared to hold it to maturity," Ablin cautions, "so that liquidity doesn't matter. "
Watch special coverage of the municipal bond crisis, "Muni Maze," all day Monday, February 14 on CNBC.