State and cities are in a world of pain at the moment as they face another year of gut wrenching (and politically unpopular) service cutbacks and layoffs. Once again they must balance their budgets in the face of possible declines in Federal funds to states and drooping real estate tax revenue. That cold reality combined with the prediction of influential analyst Meredith Whitney that numerous municipal bankruptcies could be coming down the pike, fueled a three-month long drop in municipal bonds. In the last two months, $25 billion has also been withdrawn from mutual bond funds.
Could this be a buying opportunity?
Hunting for Value in the Municipal Bond Market
Municipal Bonds absolutely offer some good buys at current prices, say some experts. The trick: separating the good from the bad, something the municipal market is remarkably bad at, according to Rick Ashburn (photo), chief investment officer for Creekside Partners. “What we’re seeing out in the market is all types of muni bonds have traded off, prices have dropped, yields have come up,” says Ashburn. And “the good bonds and the bad bonds are all selling at the same price.” With Municipal Bonds offering 5.5% and 6% yields, compared to closer to 3.4% for a 10-year Treasury note, Ashburn has advised clients to overweight munis in their portfolios.
In his column Monday, LA Times personal finance columnist Tom Petruno sums up the state of the muni markets:
Still, there is always opportunity in market chaos: Think of the corporate junk bond market two years ago and the stock market last spring. Somebody is going to make good money picking beaten-down muni bonds. How much time — and courage — do you have?
Famed bond investing expert Bill Gross, co-founder of bond fund giant PIMCO, is among those whose found the courage. In an interview with CNBC December 28, Gross explained why he’d recently put $5 million of his own money into 5 PIMCO bond funds: yield. With some muni bonds in California, New York and elsewhere offering yields of as much as 7%, he felt the potential reward outweighed the risk. (video below)
For those who aren’t full-time bond watchers, the $2.7 trillion “muni” market can be daunting to research. Made up of issues from hundreds of different entities, of all different sorts, munis vary widely in their structure. Most important for investors, there is much variation in the source and security of the income streams that support their interest payments. A muni can be a plain vanilla general obligation bond issued by a state or city, or it can be the borrowings of a local public utility, or even a non-profit hospital’s debt. The common theme is that the interest payments are not taxed by the federal government, and in some cases are free of state and local taxes too.
Looking for a way to get started, we asked Creekside’s Ashburn for his thoughts on how an investor can navigate this complicated and often ill-understood market. In his current role, Ashburn advises individuals on their investments. For twenty years prior he worked as an investment banker putting together $1 billion worth of muni debt deals.
Ashburn’s Rules of Municipal Bond Investing
To Ashburn there are some simple steps to take that can help investors see past the current worries about the muni market overall, and ferret out some gems. “There’s an awful lot of throwing babies out with bath water,” right now says Ashburn. “I don’t want to gloss over the extreme financial stress state and local governments are facing…But I look at credit risk as binary. Either there’s a risk I don’t get paid or there’s not. If there’s a scenario I can imagine where I don’t get paid I give it a thumbs down. I don’t care if [credit rating agency] Moody’s gives it an Aaa.” [Aaa is Moody’s highest rating for a municipal bond.] Here are some basic rules that Ashburn thinks can help investors minimize risk:
- Buy General Obligation Bonds, or bonds of essential municipal utilities, especially those that have the ability to raise rates if necessary.
Ashburn advises investors look for “General Obligation” in the title of the bond or some sort of utility revenue, such as sewer, water or electric. “Those are my simple heuristics with which the average investor can be 99% sure they have a really high quality bond,” says Ashburn.
High quality is important to Ashburn whose very first questions are always “Who’s paying me back?” “Where’s the money coming from?” and “What are the chances something might interrupt the ability to pay that back?” He wants to buy into bonds with an interest payment with established funding that will not be up for a vote, but is instead the beneficiary of a “sequestered income stream.” Anything that voters or elected officials have to revisit periodically and appropriate funds for he stays far away from.
Historically general obligation bond holders have always been paid back with interest, Ashburn notes, and have consistently been protected by the courts. It’s the investors in special purpose entities that run into trouble that have sometimes gotten the short end of the stick. For that reason, Ashburn avoids buying the debt of non-profit hospitals, or other enterprises whose vulnerabilities are hard to assess. By contrast, “water utilities or electric utilities are relatively safe monopolies. They can’t go bankrupt and go away. A water system can’t go out of business. Municipalities don’t go out of business. Chapter 9 [the governmental equivalent of Chapter 11 private bankruptcies] does not provide for liquidation of the enterprise,” says Ashburn. “It doesn’t work like that.”
In PIMCO’s most recent piece on the outlook for the muni market, John Cummings, head of the firm’s Newport Beach (California) municipal bond desk was less enthusiastic about general obligation debt (which he worried would continue to be hit by drops in sales and real estate taxes) but agreed with Ashburn’s take on essential service revenues like water, sewer and public utilities.
- Bond funds give you diversification, but stick to those holding high-quality Muni bonds.
Bond funds give investors diversification, but, Ashburn warns, that’s not always a good thing. If a fund is adding lower-quality credits in its drive for broader holdings, that can be a drag on future performance. With a fund that can hold 1,000 names versus the three or four individual bonds a typical investor might buy, “you get diversification,” says Ashburn, “you spread your risk out. The down side is they’re full of stuff I frankly wouldn’t want to own. It’s a tough trade off for an investor.” I
f you are more comfortable with a fund, he says looking for funds with “high quality” or “AAA” in their names as signals that they are focused on the better issuers. Once you’ve bought into a fund, you need to keep an eye on it. Twice a year, go to the fund’s website and look through their materials. In addition to looking at what the fund’s investing in, he advises that you check whether the manager is the same, or has he or she been replaced and by whom?
- Don’t Buy Long-Term Municipal Debt.
“A 4% yield on a 5-year bond, or 6% on a 30-year bond? 4% on 5-years is way better,” says Ashburn. “Inflation will come back. It’s as certain as the sun coming up and gravity. There will be low single digit inflation over the long term and it will grind you down over time. Bond yields will rise with inflation. The only way you get burned is if you keep your money tied up too long.”
Ashburn’s ok with including 10-year bonds in a ladder of bonds coming due at different times, but he advises that the average maturity of any ladder, or any investor’s holdings, should be no longer than three to five years. If you pick shorter investments, you’ll have the chance to replace those with new bonds offering higher inflation-adjusted returns when they come due in 3 or 5 years. “Keep your maturity short. Don’t be tempted into buying 25 or 30 year bonds. That’s what Ben Bernanke wants you to do because 25 years of 4% inflation wipes out half of the nations’ debt. Who paid that? Bond holders. Their interest barely kept up with inflation, so at the end they only end up with the money they put in and prices are twice as high. That’s a bad deal,” says Ashburn.
- Don’t Pay Too Much for Municipal Bonds.
Even with the decline in the market overall, Ashburn still finds some bonds too expensive. He advising clients against California general obligation bonds because at 3% on 5-year paper they don’t offer enough yield for the money. Instead he likes issues like Elk Grove Unified School District which is paying 2% higher than the state “for less risk.” Because he expects inflation to pick up, Ashburn thinks 10-year debt that yields under 4.5% is not worth looking at period.
In the secondary bond market, zero coupon bonds are especially cheap right now. They don’t pay interest over time, but pay it all at maturity and investors, already spooked, aren’t willing to chance that. But for high-quality bonds that fit his parameters, Ashburn likes them.
Please add your insights and ideas to the the comments below.