Best bargains in Muni Bonds Now (Barrons)

How to Play the Panic in Muni Bonds
By RANDALL W. FORSYTH

For several months, panicked investors have been pulling cash from muni-bond funds. For investors of means, that presents an opportunity to lock in high tax-free yields for a decade or more.

Since mid-November, panicked sellers have yanked about $26 billion from muni-bond funds, disrupting a usually orderly market. For investors of means, that presents an opportunity to lock in high tax-free yields for a decade or more.

Doing so, however, takes more care than buying a muni exchange-traded fund or closed-end fund.

The undeniable crisis in public finances has moved from the political background to the top of the news in recent months. The demonstrations by Wisconsin public employees protesting the governor's drastic measures to close the state's budget deficit are only the most dramatic examples of the fiscal pressures being felt all across the nation.

But the budget problems in states and localities are not nearly as dire as those of the sovereign debtors in Europe, though you might not know that from the coverage in the popular media. Most notably, analyst Meredith Whitney predicted an imminent day of reckoning for state and local governments in a December interview with CBS News' 60 Minutes. "You could see 50 sizable defaults," she asserted. "Fifty to 100 sizable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."


Last week, a consulting firm formed by "Dr. Doom," Nouriel Roubini, chimed in with a similar forecast of $100 billion of defaults, which had no discernible impact on the muni market.

Whitney's unsupported prediction of default -- vastly in excess of that seen in the Great Depression of the 1930s -- helped push muni prices down about 10% for long-term bonds. Her assertions have been met with a deluge of criticism from muni-bond professionals, as well as in the pages of Barron's and on Barrons.com. Yet many pricing anomalies persist. Investors willing to buy individual bonds and hold them to maturity can get yields as high as 5% on highly rated paper. That's equivalent to a taxable yield of nearly 7.7%.

The bonds themselves provide the assurance of repayment of principal at maturity, which provides a measure of confidence even as their prices may fluctuate. Mutual funds, whether equity or fixed-income, are worth only what they fetch that day; there is no assurance that they will recoup their losses and return the original investment.

Among the securities to look for are bonds backed by clearly defined sources of money, including thruways, water and sewer systems and state lottery revenues.

Profiting from Panic
Other factors also conspired to make for a perfect storm for municipal bonds. The Treasury market -- which determines the broad trend in other bond markets, including munis -- also has been under pressure until recently as yields rose on increasing fears over inflation and investors' preference for risk assets. In addition, the end of the Build America Bond program on Dec. 31, which provided a federal subsidy to states and localities issuing taxable bonds, added to pressures. The BABs program meant less issuance of traditional tax-exempt securities, which had bolstered their prices and kept a lid on their yields. The sunset of BABs at the end of 2010 lifted that lid. The BABs program also was important in broadening the municipal market to institutional and global investors not interested in income free from U.S. income tax, the main lure for American individual investors.

The carnage is particularly visible in the iShares S&P National AMT-Free Municipal Bond exchange-traded fund, a quick and easy proxy for the muni market. It shed more than 10% in value from its peak in August to its trough in January and still trades 6.4% below its high.

In the process, extraordinary values have emerged as yields on tax-exempt municipals rose to equal or even exceed those of taxable Treasury or corporate bonds. Taking in munis' tax advantage, high-quality tax-exempt bonds exceeded the after-tax yields on junk bonds. Around the muni market's nadir in January, tax-free yields on investment-grade California general-obligation bonds were higher than the yields on lower-quality, fully taxable bonds of Mexico or even Colombia.

While that portion of the investing public who take their investment cues from TV were stampeding out of munis, savvy and sophisticated investors were going the other way. And even as a backlash against the doomsayers for their unsupported predictions of multibillion-dollar defaults increased, they dismissed their critics as peddlers of munis merely defending their turf.

Other disinterested and distinguished observers have pointed out how undervalued munis are.

MKM Partners' chief economist and strategist, Michael Darda, who made a perfectly timed call to buy deeply depressed but high-quality corporate bonds at the depths of the 2008 financial crisis, called valuations on munis "increasingly compelling" with higher prospective after-tax returns than medium-grade corporate bonds or equities.

David Rosenberg, chief strategist at Gluskin Sheff, one of Canada's top wealth-management firms, adds that only single-B junk corporates provide the same after-tax yield as investment-grade munis. "I can't think of a security that is going to provide a U.S.-based investor a 7% annual return for the next decade with such little risk attached -- not equities, not corporates, not commodities. I still think this is the biggest opportunity out there in the investing world today and the most glaring price anomaly."

As the pace of fund liquidations has slowed to about $1 billion a week from $4 billion at the worst of the exodus in January, the muni market has begun to recover, with the iShares muni ETF up about 5% from its mid-January trough. In addition, issuers of municipal bonds deferred new offerings amid an inhospitable market.

Despite the undeniable value that munis represent, the dilemma remains for investors. As the news coverage of the budget battle raging in Madison, Wis., dramatically shows, state and municipal finances never have been under such stress.

But, as Clifford D. Corso, chief executive and chief investment officer of Cutwater Asset Management, points out, debt service makes up a small part of the expenses for states and localities -- in contrast to the sovereign debtors of Europe, for which interest and principal payments place a huge burden on their budgets.

The impact of the budget cuts being played out in state capitals and city halls across America will fall on public schools and the poor, as Howard Cure, director of municipal research at Evercore Wealth Management, a New York firm that manages separate accounts for high-net-worth individuals and families, ruefully observes.


Moreover, muni pros agree that states and localities have powerful incentives not to default in order to maintain their access to the capital markets. That is a direct contrast to the mortgage market, to whose parlous condition the municipal market has been compared, not entirely aptly. Borrowers whose mortgage balances are greater than their homes' values have engaged in what's euphemistically called "strategic defaults."

Yet the pressures on municipal finances are "episodic, not systemic," Cure adds. In other words, not every city is in the same dire straits as Harrisburg, Pennsylvania's capital, which averted default through by an advance from the state.

The greater risk in municipal bonds, most market professionals agree, is the same as for all fixed-income securities -- higher yields resulting from a more ebullient economy, rising inflation or both, which would be expected to lead to further losses. That has them taking some tacks that may appear counterintuitive.

Ken Woods, who heads Asset Preservation Advisors in Atlanta, which specializes in fixed-income management for high-net-worth individuals, is targeting a slightly longer duration for his clients' portfolios, which are concentrated in the intermediate-maturity range.

But for lengthening duration -- in a structure called a barbell -- he is concentrating on the very shortest maturities, under two years, and relatively longer ones out to eight-to-12 years. In the process, he's avoiding the middle of the range, which would be hurt the most by an increase in short-term interest rates by the Federal Reserve.

Corso of Cutwater Asset Management is taking the same barbell approach, concentrating on the short end and the long end of the market and avoiding intermediates. That is a strategy to deal with the extreme steepness of the muni yield curve -- the much greater yields paid on the longest maturities relative to shorter ones, which are anchored by the Fed's targeting of the overnight federal-funds rate near zero.


THIS ISN'T EUROPE
Headlines blare news of state and local budget woes, but many munis promise handsome returns. Especially appealing: bonds issued by agencies facing only modest retiree benefit costs.


Sample Portfolio
Maturity S&P Moody's Book Yield*

Texas A&M University 5/15/2012 AA+ Aaa 0.57%
San Antonio TX Elec & Gas 2/1/2014 AA Aa1 1.38
State of Pennsylvania GO 2/1/2014 AA Aa1 1.22
State of South Carolina GO 3/1/2016 AA+ Aaa 1.81
State of Utah GO 7/1/2016 AAA Aaa 1.85
Sutter Health - California 8/15/2016 AA- Aa3 3.37
Salt River Arizona Power Authority 1/1/2018 AA Aa1 2.53
State of Virginia GO 6/1/2019 AAA Aaa 2.54
Ascension Health - Michigan 11/15/2019 AA Aa1 3.87
State of Delaware GO 3/1/2020 AAA Aaa 2.75
State of Maryland GO 3/1/2021 AAA Aaa 2.90
Water/Sewer District of Southern California 3/1/2022 AAA Aaa 3.50
State of Texas GO 4/1/2023 AA+ Aaa 3.49
Massachusetts Institute of Technology 7/1/2023 AAA Aaa 3.42
State of North Carolina GO 5/1/2024 AAA Aaa 3.53
NYC Transitional Finance Authority 2/1/2025 AAA Aa1 4.17
Massachusetts Bay Transit Authority 7/1/2026 AAA Aa1 4.17
NYC Water/Sewer Authority 6/15/2028 AA+ Aa2 4.42
Charlotte NC Water/Sewer 7/1/2030 AAA Aaa 4.23.
Harvard University, Mass. 12/15/2031 AAA Aaa 4.27
Tallahassee, Fla. Health Facilities 12/1/2030 NA Baa1 6.43%
Halifax Hospital Medical Center, Fla. 6/1/20206 A- BBB+ 5.70
Northampton City, Pa., Hospital Authority 8/15/2024 BBB+ A3 5.58
Michigan Hosp. Fin. Auth. (Ford Health) 11/15/2039 A A1 6.28
Iowa Higher Ed. Ln. Auth. (Grinnell Col.) 12/1/2020 AAA Aaa 3.12
State of Washington GO 1/12/2020 AA+ Aa1 3.00
Illinois Fin Auth. (Swedish Covenant Hosp.) 8/15/2029 BBB+ A- 5.81
Denver City & Co Sch Dist. Colo 12/1/2021 AA- Aa2 3.30
*As of 03/02 Sources: Cutwater Asset Management & Asset Preservation Advisors
.
The muni yield curve's steepness parallels that of the Treasury market out to 10 years, but it becomes even more extreme for lengthier maturities. Two-year triple-A munis yield about the same as the two-year T-note -- as of March 3, around 0.72%. At 10 years, the muni yields 3.20% vs. 3.52% for the Treasury. But in 30 years, the muni yields 4.72% vs. 4.60% for the Treasury. For a taxpayer in what for now is the top federal tax bracket of 35%, the top-grade muni yields the equivalent of 7.26%, the same as better-grade corporate junk.

If, or when, the steepness of the muni yield curve corrects, with short- and intermediate-term yields likely moving higher, those on the short end of the barbell will be trading as near-cash equivalents and will be able to be redeployed at higher returns.

Historically, the long end typically doesn't move much in those circumstances, so the investor picks up significant yield with little price movement. In the less likely event the curve flattens from the long end, the lengthier maturities would rally.

Woods also is emphasizing medium-grade (triple-B and single-A) bonds to a greater extent since going down the quality scale provides greater-than-usual pickups in yield. But he does that for only some 15%-20% of portfolios, with 80%-85% in double-A or triple-A bonds instead of his usual 85%-90% in top grades.

Another emphasis is on longer-term, high-coupon callable bonds. For instance, instead of buying a bond maturing in eight or 10 years, Woods might buy a bond due in 18 years but callable in eight years with a high enough coupon to ensure it is called. These so-called kicker bonds provide a higher yield and lower volatility than comparable non-callable bonds. That's in part because they trade at a significant premium to par, and individuals not steeped in the arcane math of bonds are loath to pay above par.

Cure of Evercore emphasizes bonds outside the battlegrounds of budget deficits and future pension and retiree health-care benefits. While the news focus is on states and cities, there are thousands of bonds that are issued by various agencies. These securities have structures with clearly defined sources of money, either dedicated tax payments or revenues from the projects they finance.

In New York, Cure explains, personal-income-tax payments are dedicated to payment of bonds of the Housing Finance Agency, the Dormitory Authority and Thruway Authority. In Florida, there are bonds secured by state lottery revenues, which have to cover debt service three times.

Revenue bonds to finance essential services such as water and sewer systems also have the virtue of being relatively immune to vagaries in the economy, which affect income and sales-tax revenues. In addition, localities which depend on real-estate levies have been depressed by the drop in house prices.

Meanwhile, those authorities also have relatively few employees and lower future retirement liabilities than, say, school districts.

And just think of the satisfaction you'd get paying the toll on George Washington Bridge if you owned bonds of the Port Authority of New York and New Jersey, which operates the Hudson River crossing.

.E-mail: editors@barrons.com

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