By: Robert Gordon
By: Rob Gordon, MBA, CFP®, AIF®
The media is heralding the relatively attractive yields available today in the municipal bond arena. This is measured by comparing the yield offered on the highest quality municipal bonds against the yields offered by U.S. Treasury securities of similar maturities. Normally, municipal bonds (“munis”) have lower yields than Treasuries. However, today, munis sport significantly higher yields and that yield advantage increases if you take into account the tax exemption. A number of factors explain this historical anomaly and suggest that investors should be wary of calls to “load up” in any single asset class or security.
Municipal bonds are debt obligations issued by states, cities, counties and other public entities which use loans to fund the construction of hospitals, schools, highways, sewers and universities. A primary feature of these bonds is that the interest you receive may be exempt from federal income taxes. It may also be exempt from state and local taxes if you live in the state where the bond is issued.
Historically, yields on municipals are 80% to 90% of the yields on U.S. Treasuries. At the end of 2007, they shot up to parity or 100% of U.S. Treasury yields and for most of 2008, they have traded between parity and 150% of U.S. Treasuries. The table below shows just how attractive municipals are today relative to treasuries.
|Date 10/23/08||National Average AAA Insured||US Treasury|
Municipal bond interest is exempt from federal taxation meaning that a yield of 4.85%, as shown above, for a 10 year municipal bond is a tax-adjusted yield of 7.46% for a person in the 35% marginal tax bracket. The primary reasons for the historically wide differential are: capital scarcity, threats to the municipal bond insurance industry and threats to the national and local economic base.
The scarcity of available capital has had repercussions throughout the markets. Our economy runs on credit and the credit crunch is affecting every issuer of debt. The market is demanding higher and higher yields to attract capital from treasuries whose prices have risen dramatically (and whose yields have declined) as investors search for “safe” places to put their money. This situation is exacerbated by the demise of the auction rate security market earlier this year. That market was an important source of short term funding for municipalities and the absence of that liquidity has also contributed to the higher cost of funds reflected in the higher yields. Additionally, financial institutions such as banks are some of the primary participants in the municipal debt market. With the dramatic consolidation that is occurring in that industry, many players have been sidelined until their situation normalizes.
Investment grade municipal bonds, as a category, have a very low default rate as compared to investment grade corporate bonds. According to Moody’s rating service, the 10 year default rate of all investment grade corporates is 2.09%. The same rate for all investment grade muni bonds is 0.07%. Despite these low default rates, estimates are that approximately 50% of all investment grade munis are insured. Typically, the issues that are insured are strong credits from not very well known issuers. The bond insurance basically lowers the issue’s credit risk and substitutes for good due diligence on the part of the buyer. So what happens when the underwriters of this type of insurance have financial problems? The value of the insurance coverage they offer becomes impaired. Late last year, the stock prices of underwriters such as Ambac and MBIA, two market leaders in insuring municipal bonds, declined over 90% as the mortgage debt they had underwritten as insurers began to unwind. Their lack of financial stability destroyed the value of the insurance on the municipal bonds they underwrote. The market, reacting to the increased risk, reduced the prices on those issues thereby increasing yields throughout the market.
While defaults in municipals are rare, they do occur. So far this year, according to Distressed Debt Securities Newsletter, $2.4 billion in municipal bonds have defaulted, up substantially from $324 million for all of 2007. State and municipal budgets, already squeezed in the credit crunch, are getting hit by declining tax revenues due to a declining economy. As a matter of fact, Jefferson County, Alabama threatens to be the largest municipal bond default in U.S. history. This county is the largest in Alabama and includes the city of Birmingham. The country utilized variable rate debt instruments including various derivative securities to finance the modernization of the county’s water and sewer system. In February, the county’s interest rate soared to as much as 10 percent, up from 3 percent just weeks earlier. 1 Overcome by the combination of increased interest rates and declining usage revenues due to the economic downturn, on March 7, 2008, Jefferson County failed to post $184 million collateral as required under its sewer bond agreements, thereby moving into technical default.2
In the end, the return reflects the risk inherent in these uncertain times. Markets work and, in times like these, it is vitally important to remain well-diversified with exposure to a number of asset classes. An example of the inability of individuals to forecast or predict market moves is one in which an investment advisor was recently quoted in the Christian Science Monitor suggesting that investors should avoid municipal bonds from communities hardest hit by the housing market downturn in favor of those issued by Midwestern communities who are benefiting from the recent run-up in agricultural commodities. He failed to mention or perhaps he was not aware that agricultural commodity prices have declined over 60% this year alone rendering the premise for supposed strength in these communities nonsensical. As always, caveat emptor!
- 1 William Selway and Martin Z. Braun (May 22, 2008) “JPMorgan Swap Deals Spur Probe as Default Stalks Alabama County” Bloomberg
- 2 Wright, Barnett (March 8, 2008) “Jefferson County, Alabama sewer debt swap agreement deadline passes.” Birmingham News
This article does not constitute an endorsement or recommendation, either explicit or implied, of these or any other securities mentioned.