Notes, Views, and the Occasional Provocation January / February 2011 

California and Greece have a lot in common – expansive coastlines, good food, and a Mediterranean climate. But when it comes to their debt, they don't deserve comparison. As a percent of GDP, Greece's debt is over 100%, while California's is a world away at less than 5%.

Investors reading the morning headlines, however, may not be able to tell the two apart. That's how scary the recent news has been about potential municipal defaults. Most of the concern about creditworthiness is overblown. But as the article below discusses, the Credit Crisis of 2008 may well have permanently altered the landscape of municipal-bond investing, and investors should pay attention.

Warm regards,

Milo Benningfield

Perception Becoming Reality in the Municipal Bond Market
If the stock market is often a raucous party where loud music blares and drinks are plentiful, the municipal-bond market down the hall has traditionally been a softly lit lounge with Muzak and a quiet conversation here and there. Not these days. more

BFA Media Quotes
Recent media quotes. more

Perception Becoming Reality in the Municipal Bond Market
If the stock market is often a raucous party where loud music blares and drinks are plentiful, the municipal-bond market down the hall has traditionally been a softly lit lounge with Muzak and a quiet conversation here and there. Not these days. Reporters, pundits, and politicians have burst into the room, ostensibly to shine a light on a slew of impending defaults as states and cities struggle to pay for essential services and pension obligations with declining tax revenues.

In December, 60 Minutes devoted an entire segment to the crisis in state budgets, and several times a week major newspapers report on yet another municipal austerity measure and the petrified bondholders counting on their investments for retirement income.

Is all the concern justified? Yes, but not for the reasons typically stated. Concerns about contract law and continued access to capital markets will likely persuade all but a few municipalities to make good on their bond promises, no matter how dire their financial straits become. But the Credit Crisis of 2008 does appear to have fundamentally altered the municipal-bond landscape, and muni-bond investors will need to recalibrate their expectations going forward.

Municipal bonds, or "munis," are issued by cities, counties and states and other entities to pay for projects like bridges, sewers and schools. Though muni-bond investors would protest being characterized as "yield chasers," it's nonetheless true that the bonds' tax-exempt status is one of their primary attractions. An investor who'd have to give up 35% of her earnings to federal income taxes on a Treasury bond yielding 5% could keep every cent she earned on a muni bond yielding 4%.

This gives the muni bond a "tax-equivalent yield" of 6.2% – almost 25% more income than the 5% Treasury. The higher the investor's tax rate, the higher the savings. Plus, if the investor lives in the state where the muni bond is issued, the interest income is also exempt from state and local taxes – or "triple tax free."

Much of the current fuss being made over potential muni-bond defaults is, as one commentator put it, sheer opportunism by people aiming to increase their own visibility. Historically, the muni default rate has been miniscule, less than one-half of one percent. Corporate borrowers have defaulted at a rate of about 5%, so muni-bond defaults could increase fivefold and still be half that.1

The default rate on higher-grade munis is even better. According to a 2009 study by Moody's, between 1970 and 2009, rated muni bonds suffered only 54 defaults. Also, when the headlines talk about "potentially billions of dollars" in defaults, remember this: municipal bonds are a $2.8 trillion market. In 2010, actual municipal defaults totaled $2.65 billion, or about 0.095% of the muni market.

No one knows what the default rates will be going forward. But reports of recent muni-bond purchases by large institutions – so-called "cross-over buyers" – suggest the smart money is betting on the long-term viability of muni bonds. These investors understand how badly cities and states need to maintain their access to the capital markets. They also understand that many of the headlines that most scare individual muni bondholders, the ones reporting on services cuts and pension negotiations, reflect not an increased risk of defaults, but rather the lengths to which municipalities will go to favor distant bondholders over their own local residents.

But if default rates aren't likely to change much with muni bonds, something else has: investor perception. Because of the peculiar nature of muni-bond purchasers, this is cause for concern.

As noted, under normal circumstances, most muni-bond purchasers are individuals, since they, more than institutions, benefit from the tax advantages. They are individuals, moreover, who cluster in the higher tax brackets. Economically speaking, they resemble one another, residing in similar neighborhoods, eating at similar restaurants, and expressing similar consumer and investment-risk preferences in a variety of ways.

This homogeneity of muni-bond purchasers means that a single trigger can spook the whole group enough to cause a stampede for the exits. When this happens in any asset class, prices begin to fall, creating a cascade effect in the market as other investors dump their own assets to avoid getting stuck with further losses.

In the near term, the risk of a muni-bond stampede may be higher than before the Credit Crisis of 2008. Investors have already been spooked and many are liquidating even highly rated bonds, since few of them trust the credit-ratings agencies such as Moody's and Standard and Poor's.

Nor is bond insurance widely available anymore to reassure investors. The insurers have gone out of business or been downgraded to junk status, so cannot offer their own high credit rating to be used by lower-grade municipalities.

On a more positive note, there's a limit to how far muni bond prices could drop, since even now, institutions and sophisticated individual investors are swooping in to seize muni bonds at prices that are starting to be as attractive as those during the credit crisis.

Longer term, there could well be a fundamental shift in how investors perceive risks in the muni-bond market. Fewer individual investors may be willing to accept a muni bond into their portfolio based on nothing more than the equivalent of a FICO score. Blanket stamps of approval based on insurance or credit ratings would be replaced by a need to perform extensive due diligence on each municipal issue. In this respect, the muni market would become more like the corporate-bond market.

To compensate investors for less reassurance and the need for more due diligence, muni-bond yields would probably rise. Historically, muni bonds have traded in tight spreads to Treasuries, offering about 80% of the Treasury yield. Going forward, muni yields could settle in at 90% of Treasury yields.

Of course, a rising interest-rate environment will affect all bonds, not just munis. How this environment will interact with increased municipal borrowing costs to affect other factors in the muni-bond market is another unknown. There are lots of questions to be answered. At the very least, muni-bond investors should be asking them. Investors who have concentrated their bond holdings in munis should probably reconsider. If they want a guarantee of repayment more than a tax advantage, they'll need to look to Treasuries, which are backed by the federal government's ability to print money.

In some ways, what's happening in the muni-bond market is merely the final shoe to drop from the credit crisis two years ago and resulting recession. All economic shocks take a while to show up in tax revenues and thus municipal finances.

But while the stock markets may be partying as hard as ever today, with prices having reached pre-crash levels, it's probably best for muni-bond investors to acknowledge that something's shifted in their lounge. It can be comforting to hang around people who walk and talk like you do. But when it comes to investing, it can be risky, too.

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BFA Media Quotes
The New York Times, January 21, 2011
Milo was quoted in an article by Tara Siegel Bernard, "With Retirement Savings, It's a Sprint to the Finish." The article discussed the vulnerability of investors in the last decade before their retirement, when they typically count on good investment returns to double the size of their assets. The article stated:

"It's the cruel irony of retirement planning that those people who most need the markets' help have the least financial capacity to take the risk," said Milo Benningfield, a financial planner in San Francisco. "Meanwhile, the people who can afford the risk are the ones who least need to take it."

Read the article.

Thank you for reading. Please look for our next newsletter in March.

Best regards,

Milo Benningfield

1 A "municipal" default is not as drastic as it sounds and can be something as temporary as a missed interest payment on a bond. Municipal bankruptcy, a rarer event than defaults, is another matter; here a court must decide how much investors get back. The good news: they almost always get all their money.

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