If there is a lesson to be learned from the stock market's recent slide-triggered by massive losses on exotic instruments and mortgage-backed securities-it's that nothing is wrong with simple, plain vanilla investments. For your clients' fixed-income portfolios, now may be a desirable time to be thinking of investing in municipal bonds and municipal bond funds as opposed to U.S. Treasurys. But beware of certain risks that today overhang what was once one of the safest markets in which to play.
Thanks to an extended stretch of weakness and volatility in the muni market, muni bonds at both the short and long end have yielded more than Treasurys on an absolute basis. How much more? As of this writing, the 30-year triple-A-rated muni, normally the benchmark for the market, has been trading at around 114% of the 30-year Treasury (normally they trade in the range of 85% to 90%, reflecting their exemption from federal income tax and, in some cases, state and local taxes as well). Indeed, on one occasion in late February 2008, munis traded as high as 140% of Treasurys when the market for auction-rate securities failed. The typical 10-year triple-A-rated muni in mid-March was trading at around 110% compared to the 10-year Treasury, which normally trades in the upper 70s or low 80s.
Last year was a particularly tough year for the muni bond market. The Lehman Brothers Municipal Bond Index underperformed Lehman's U.S. Aggregate Index by 17 basis points in 2007.
Hedge funds scorched
One factor was the squeeze put on bond insurance companies, which suffered credit downgrades related to the subprime debt they had taken on their books during the booming housing market. Another reason munis underperformed was that hedge funds were forced to sell them to meet margin calls and stay afloat. This in turn helped drive down prices and upped muni yields to levels not seen in decades.
"I've been managing bonds for 20 years, and I've never seen anything like this. It's been an amazing period for something as sleepy as a muni bond," says Alexander N. Feick, managing director of Paragon Capital, a wealth management firm in Denver that manages more than $125 million in municipals for clients. "Right now, they're throwing in the insurance for free."
Traditionally, fixed-income investors have taken comfort in the triple-A ratings of their bonds, but many today are investing in munis without that margin of safety. Reason: Triple-A insurers have become a scarce commodity after the many subprime-related downgrades.
"In the past, about 60% of muni bonds were insured with triple-A ratings, whereas today the ability of many of the insurance companies to maintain that triple-A rating is questionable," says bond expert Hildy Richelson, co-author of Bonds: The Unbeaten Path to Secure Investment Growth (Bloomberg Press, 2007) and four other bond books. Richelson, an RIA in Blue Bell, Pa., says that historically a major component of stock market returns has been returns from dividends. Since many stocks today yield either low or no dividends, bond yields by comparison are extremely attractive. She says the power of compound interest is often misunderstood.
In a recent report, Paul Herbert, a fixed-income strategist at Morningstar Inc., calls muni bond funds "a steal" today. Morningstar covers some 700 open-end muni funds, which include single-state, national and high-yield muni funds. It also tracks 14 new EFT funds that invest in municipals. Morningstar does not track closed-end funds. Among the top funds are the Fidelity Municipal Income and Vanguard Intermediate Tax Exempt funds. Single-state muni funds from Vanguard and Fidelity are also worth considering, Morningstar says.
In a further sign prices of munis are cheap, billionaires Wilbur Ross, Warren Buffett and bond guru Bill Gross of Pacific Investment Management Co. (PIMCO) recently piled into the market. Buffett and Ross were not only eager to buy munis, but to insure them as well.
"Muni market on sale"
"The whole [muni] market is on sale," says Eaton Vance chief economist Bob MacIntosh, who is co-director of the firm's municipal investments. "The market has definitely put a discount on insurers who face trouble."
"We're not doing anything different than we have been for decades," MacIntosh adds. "What we're finding is opportunities in insured bonds in ways that would not have happened if there weren't all this turmoil with their ratings."
Dan Solender, director of municipal bond management at Lord Abbett & Co., calls recent moves in the muni sector unprecedented. "It's a crazy environment because a year ago we were buying high yield bonds on the municipal side in the 5.25% range. This year, we're buying triple-A and double-A rated bonds at that range." Lord Abbett, which manages approximately $9 billion in tax-free mutual funds and separately managed accounts, has set up a Web resource page (www.lordabbett.com/muniresources) with educational material about the muni bond market.
Remarking on the entrance of hedge funds buying and selling munis, Solender says, "Ten or 15 years ago, it used to be mainly people looking to buy just munis, whereas now hedge funds have come in, and we've had different cross-over accounts. There's a lot more relationships between our markets and other markets."
Taking their cues, advisors and wealth managers are beefing up their clients' fixed-income portfolios with muni products. Others say current conditions could be a harbinger of worse to come and are holding off. Andy Berg, a partner at wealth management firm Homrich & Berg in Atlanta, says he is moving clients rapidly out of Treasury-Inflation Protected Securities (TIPS) into munis. "Tax-equivalent yields in munis have risen significantly while yields on TIPS have fallen precipitously," Berg notes. "We're sticking to double- and triple-A (rated) bonds, given that the risk in muni bonds is a little bit higher than it has been historically." Moreover, Berg looks for prices of munis to climb because of the possibility of higher income tax rates regardless of whoever gains the White House in the upcoming election.
Wealth manager Paul S. Baumbach, a principal of Mallard Advisors LLC in Newark, Del., agrees because of the possibility that many of the Bush tax cuts could expire in a new administration. Baumbach is particularly selective. "I don't just buy any municipals," he says. "I make sure my credit quality is high and that the maturity is within a range I'm comfortable with- relatively short. I'm restrictive in avoiding AMT [alternative minimum tax] bonds; I hold them until maturity to keep the cost to the client low."
When about to purchase a large amount of municipal bonds, he has begun using an exchange-traded fund (the iShares S&P National Municipal Bond Fund). "It permits me to invest quickly, cheaply, and it doesn't require that I hold it to maturity," says Baumbach.
Richelson sees opportunity in the longer end of the market since her clients are buy-and-hold investors. Residents of high income states such as New York like locking in muni yields of 4.5% that provide taxable equivalent yields of 7% to 8%, while New York City residents reap even more of a benefit, she says.
Josh Gonze, co-portfolio manager of Thornburg Municipal Bond Fund, is bullish on munis. "Ratios over 100% are highly unusual," he says. "In our view, sticking to high quality munis is the way to go. The only municipal sector with a high risk of default is real estate, and we stay away from it." Thornburg's five open-end muni funds are available to advisors in institutional share classes with no loads.
Russell Wild, a CFP licensee in Allentown, Pa., says munis look attractive but warns against being hoodwinked by higher yields alone. "Yields can and do change over time, so an attractive current yield is no reason to go whole hog on any particular asset class-munis included. Now may be a time to overweight munis within a bond portfolio; it is not a time to abandon the diversification that comes with owning different kinds of bonds."
Risks in the Market
Risks abound, however, and advisors should proceed cautiously. Any sudden blowup in inflation could cause interest rates to spike, which would devalue not only munis but all bonds. In a period of slow growth or recession, municipalities could be hurt. There is also the risk of ratings downgrades, though bond pros see outright default by municipalities as slim.
"The risk is that tax revenues could come in less than municipalities anticipate. Insurers could continue to struggle to maintain their triple-A ratings. There's obviously a lot of bad news out there," says Scott Berry, a senior analyst at Morningstar.
The returns on open-end funds are quite straightforward, he points out. Even with the problems of insurers, the majority of investment-grade muni bond funds will be sound. With such funds, it's particularly important to watch expenses, Berry says. "Returns tend to be tightly bunched in this category. A low expense ratio can give a fund a built-in head start each year," Berry says. The average expense ratio of broker-sold muni funds in Morningstar's universe is 0.8%, in addition to a possible load, whereas the ratio is 0.65% for a no-load muni fund.
Some advisors are steering clear of munis, however, believing conditions could easily reverse. They see additional risks. "For my clients, I buy bonds for safety. Safety trumps yield in my book. I would rather take risk in the stock market where long-term gains are possible," says Bert Whitehead, who founded the Alliance of Cambridge Advisors, a nonprofit organization in Franklin, Mich., that trains and fosters holistic wealth management. He maintains that large numbers of municipalities carry unfunded or underfunded pension programs on their books and are more at risk than many think.
"As the current financial turmoil subsides and the economy recovers, it is likely the yield curve will shift up," says Mark McNary, chief investment officer for the Gensler Group, Coronado, Calif. "It isn't much consolation to an investor who bought munis cheap if the Treasury curve shifts up 150 basis points, but the muni curve rises only 130 basis points."
Triple-A Ratings Cut On Some Holdings
Moody's Investors Services recently said it is switching to a global rating system so ratings of corporate bonds can be more easily compared with their ratings of municipal bonds, which would put most muni state general obligation bonds, or GOs, at AAA-rating levels.
In response, Eaton Vance plans to change the standards for 12 of its insured closed-end bond funds, so that they won't be as restricted in what they can hold. The credit ratings on bond insurers backing the obligations no longer have to be rated AAA, and indeed can be rated as low as the high-Bs, if at least 50% of their assets are triple-A rated. Franklin Templeton, First Investors Management Co. and Nuveen Investments are taking similar actions, according to published reports.
So what does this mean?
Richelson says funds holding portfolios of muni bonds with underlying ratings of A or better reflect the types of bonds that bond insurers like to cover because of their low default rate. With lower rated bonds, you are relying on the funds' analysts, she says. However, if Moody's Global Rating Scale is substituted for the separate municipal bond scale that is currently in use, the municipal credit gradations will be blurred. "I expect traders will continue to rely on the underlying ratings of the traditional muni scale, and so should you."
Bruce W. Fraser, a freelance financial writer in New York, writes for many prominent business publications. He is currently writing a book on millionaires. He can be reached at fraserNYC@aol.com