Craig Henderson has been managing municipal bonds for 23 years, so it’s no surprise he favors them. And right now, he may like them more than ever, and not surprisingly, he’s buying.
This only sounds odd when you consider the difficult summer these bonds have just endured, after a 100 basis point increase in 10-year Treasury rates from May to June sent muni prices plummeting.
Those falling prices have not made it an easy year for Henderson’s namesake muni bond shop, C.W. Henderson & Associates Inc., in Chicago, which manages $3 billion. He says he has never had a losing year in his managed muni bond portfolios before now. But even though this year is not over, the firm was already down 1.6% as of August.
The bond market chaos began on May 1, when interest rates began the 100 point rise over six weeks. “In my 23 years in the business, there have been five other times this event happened: 1994, 1999, 2004, 2008 and 2010,” Henderson says. Though 1994 and 2004 were the worst, all five periods were bad. And the latest crash in 2013 “would be in the top two,” he says.
Investors have responded by panicking, of course. “The pendulum swung too far one way,” he says. During the month of June, fund complexes lost $4 billion to $5 billion a week to panicking investors, and the total withdrawal from muni funds was nearly $14 billion that month, the second-highest loss on record, he says.
The withdrawals forced muni bond fund managers to sell securities at a 10% to 12% discount in order to keep up. “I wish you could have every individual see how mutual funds have to conduct business, because they are selling at whatever price they can get,” Henderson says. “Tax-free fund managers were forced to liquidate at any price.”
Still, Henderson believes most of the panic is behind.
“The mindless selling into a vacuum is abating,” he says. “Now a little bit of cash is creeping back into the bond market.”
Reasons For Optimism
Two and a half months later, he now likes munis for several reasons. For one thing, they offer a better return than 10-year Treasurys (a 2.75% tax-free yield instead of the 10-year Treasury’s 2.58%).
Munis have also become more attractive because they offer tax incentives at a time taxes are rising for top earners. The American Taxpayer Relief Act of 2012 introduced the first major tax increase in 20 years, raising marginal rates for those with the highest incomes to 39.6% from 35%. At the same time, the rate for long-term capital gains and qualified dividends increased to 20% from 15%. When you add in the 3.8% Medicare surtax, this rate rises to 23.8%. Interest earned on municipal bonds is exempt from that surtax.
Henderson also likes the fact that municipal yields are currently better looking than their Treasury counterparts. The municipal/Treasury ratio, or M/T ratio, compares the current yield of municipal bonds to U.S. Treasurys, according to the Web site www.learnbonds.com. When comparing valuations of tax-free and taxable bonds, most analysts look at the yields on an index of “AAA” rated municipal bonds and the yield on the 10-year Treasury notes, says the Web site. If “AAA” municipal bonds are currently yielding 1.60% and 10-year Treasurys are yielding 2%, then the M/T ratio would be 80% (1.60%/2.00% = .80). When the yield ratio is over 100%, municipal bonds are more attractive than Treasurys, and the higher the ratio, the better.
Finally, Henderson likes that the spread between munis and zero-yielding cash has risen. And muni bond issuers are enjoying improving financial health.
He might seem overly optimistic, but Henderson’s not totally alone in his view of muni bonds. “As an oversold and undervalued asset class, the value of the tax exemption has not been this high since the 1980s,” James Welch wrote on the Web site of Castleton Partners, a boutique fixed-income shop serving high-net-worth individuals, families and foundations (www.castletonpartners.com). “Historically, one had to pay a premium for the option NOT to pay taxes on income for a tax exempt bond; now, that option is free!” Welch wrote.
For the first time in years, he added, “the tax-exempt market represents value—both on an absolute basis with materially higher tax-free yields and on a relative basis compared to taxable alternatives.” Taxable equivalent yields are in the 5%-8% range for high-quality liquid intermediate munis.
The muni market has become much more complex than it was in 1991 when Henderson, a veteran of First Boston in Chicago, founded his firm. Since then, the Internet bubble burst. Bear Stearns and Lehman Brothers went out of business, setting off a near-collapse of the financial markets in 2008. And in 2010, Meredith Whitney, a bank analyst and founder of Meredith Whitney Advisory Group LLC in New York, predicted in a 60 Minutes interview that 50 to 100 “sizable” defaults would occur in the nation’s towns, cities and counties in the following year. The press sensationalized her statements, and billions of dollars poured out of the muni market.
All these things created “chaos and opportunity,” Henderson says, and prompted his firm to make changes.
“We’ve never had research people here before,” he says. “Now we spend a vast amount of time on research. … Research has become the most important thing.”
Despite his outlook, headlines about certain issuers tend to make some investors wary of munis, and in a couple of cases, states are not even paying on their obligations, he concedes. One of the biggest newsmakers is the city of Detroit, which filed for bankruptcy. And there are other problem issuers on the horizon.
“Puerto Rico is the next trouble spot,” he says. The bonds are rated “Baa3” and “they’re on their way to junk status.” Henderson has never held them. “We’ve sold them every time we inherited them. Some mutual funds that are not allowed to own junk do own Puerto Rico bonds.” Thus, he warns, if every fund manager who holds them is forced to sell at once, watch out!
Meredith Whitney appeared shortly after Detroit’s bankruptcy filing on an online news program, Daily Ticker, and predicted “staggering aftershocks” for the muni bond market, calling Detroit’s action a “game-changing event for certain.” She says that it will “galvanize other municipalities to either get their act together or follow Detroit’s lead.”
Henderson believes many issuers are making progress. “The general overall annual budget situation in states and localities is better and almost good,” he says. “Some states are seeing a surplus.” He favors muni bond portfolios with a 13-year average maturity. That should yield about 3.6%, he says. “That’s what I’m buying.”
As part of his rosier outlook, he has increased the duration of his municipal bonds to 3.6 years to 4.2 years. To take advantage of the opportunity presented by the current situation in the bond market, he says, “investors need to keep their average maturity to about four to six years. The mistake people made in the last few months is that they ‘reached’ for the highest yield possible and ended up with bonds with very long maturities and much too much interest rate risk.”
“We’re taking a little more risk,” he adds. “We try not to take credit risk.” He sticks to general obligation bonds such as those issued by essential service utilities and private universities. The average quality is “AA+.” “We are in the stay-rich business, not the get-rich business,” he says.
And he’s still optimistic that his firm won’t lose money on these investments this year. “I still think we have a decent chance to be even for the year,” he says.
Mary Rowland can be reached at [email protected]. She has been a business and personal finance journalist for 30 years and has written two books for financial advisors: Best Practices and In Search of the Perfect Model.