April 18, 2024

Strategies: Opportunity in a Muni Maelstrom

No one has ever actually asked me that question, but I wish they had, and preferably several months ago. There have been some great deals in the muni market — including bonds issued by institutions with fine pedigrees and deep pockets, like Cornell and Harvard.

Admittedly, the muni market is not the most likely arena to make a killing these days. Until recently, munis have often been portrayed as boring investments — the ultimate Steady Eddies, providing reliable, tax-advantaged returns for wealthy coupon clippers and for not-so-wealthy retirees who have used the income to keep bread on the table.

But in the last several months, financial storms have heightened the muni market’s volatility. Headlines about severe fiscal distress in American cities and states — plus a series of dire statements by Wall Street seers predicting bigger troubles ahead — have led mom-and-pop investors to cut their muni holdings.

Since November, a net $38 billion has flowed out of muni funds, according to the Investment Company Insitute. That’s 7 percent of the market for tax-exempt bond mutual funds — the biggest four-month outflow since 1984, when the institute’s data began, according to Brian Reid, its chief economist. On top of that, many investors have been selling individual bond holdings.

This great exodus has contributed to short-term price distortions. Small investors have been hurt by selling low, and, as always, smart money has entered the fray. Speculators have had easy pickings.

“Some of the trades in this market have been very sweet lately,” said Matt Fabian, managing director of the research firm Municipal Market Advisors. Muni yields began rising in November, and prices, which move in the opposite direction, fell, hitting a trough on Jan. 14, he said.

Swept up in the price movements were some red-hot munis — including those Cornell and Harvard bonds. (Although state and local governments, as well as water systems and sewer districts, are classic issuers of munis, universities may also offer them through various means.)Traders who bought a 30-year Cornell 5 percent bond in mid-January and sold it last week would have pocketed a quick 9.3 percent profit, he said. Trading the equivalent Harvard bond over the same short period would have produced a 6.3 percent gain.

“Individual investors looked at the pricing and the yields of these bonds, and came to their own conclusion: a place like Cornell is going to be good for the money, and when the smoke clears, this will be a real opportunity,” said Thomas McLoughlin, managing director and head of municipal research at UBS.

An even bigger windfall — a 10.6 percent profit over the same period — would have come to those canny enough to have bought 30-year California state general obligation bonds, Mr. Fabian said.

California’s state finances are strained, but the chances of a bond default by California or any other state are extremely low, according to Vanguard, which issued a report in January with the title “California Is Not Greece.”

Chris Alwine, who directs the municipal bond group at Vanguard, said in an interview that while many states and municipalities are under financial pressure, and heightened market volatility is likely to continue, “We believe the risk of systemic defaults is overstated.”

There may be some “one-off defaults by smaller issuers in economically depressed areas,” he said. But, he added, “we believe that a high-quality diversified portfolio of municipal bonds is of compelling value now.”

In an analysis in October, Moody’s Investors Service found that the tax-exempt general obligation bonds of every American state are more creditworthy than 96 percent of American corporate bonds. Since 1930, not a single American state has defaulted, the report said, while corporate bonds have defaulted at an average annual rate of 2 percent. Furthermore, historical recovery rates for defaulted municipal bonds have been much higher than for corporate defaults.

Municipalities have gone into default, but rarely, said Jack Dorer, managing director of the public finance team at Moody’s. The 1994 default by Orange County was widely chronicled, but bondholders were ultimately repaid 100 cents on the dollar.

How widespread have muni bond defaults been? Mr. Fabian maintains a comprehensive database. Most muni defaults occur in bonds that are not evaluated at all by bond rating agencies like Moody’s, Standard Poor’s and Fitch.

At the moment, he said, of approximately 50,000 tax-exempt bond issuers, 272 are in default — meaning, in his terminology, that at least some payment of interest or principal has not been made. Of those 272 issues, 225 did not have a rating from a bond agency. In total, those defaulted bond issues had a face value of about $8 billion, he said.

The entire municipal bond market last year was worth $2.9 trillion, according to Federal Reserve figures — which means that roughly 0.3 percent of that market is in some state of default. That is not a large percentage. Nonetheless, several analysts have predicted waves of defaults ahead — most recently, Roubini Global Economics, a consulting firm co-founded by Nouriel Roubini, the New York University economist. Its report said that there could be $100 billion in muni defaults over the next five years, but that they would not cause systemic problems.

Even so, the $100 billion figure “seems way too high, given the historical patterns I’ve seen,” Mr. Fabian said.

In January, Meredith Whitney, an independent financial analyst, predicted a “spate” of defaults worth “hundreds of billions of dollars,” a figure that has been widely criticized. Ms. Whitney did not respond to a request for comment; members of the Roubini firm declined to comment.

Of course, the chasing of hot investments, whether munis or stocks or commodities, isn’t recommended for buy-and-hold investors. Mr. Alwine of Vanguard said muni bonds would continue to be worthwhile, especially for higher-income investors for whom the tax benefits are greatest. Diversified portfolios of highly rated bonds will provide reliable returns over the long haul, he said.

Still, interest rates for all types of bonds are likely to rise over the next year or two if the global economic recovery continues, inflation rises and central bank interventions decline, as many analysts expect.

Munis would face a headwind, and they are also likely to be buffeted by political and financial pressures, said Jonathan Beinner, head of fixed income investment at Goldman Sachs Asset Management. Does that make munis too risky to hold? Not in his view.

He has taken the somewhat unusual step of buying munis for the Goldman Sachs Strategic Income fund, a taxable bond fund. “It’s a tactical investment, not a strategic one,” he said. Over the long haul, munis may not make sense for a taxable fund, he said, but at the moment, some munis are just too hot to pass up.

This article has been revised to reflect the following correction:

Correction: March 13, 2011

The Strategies column last Sunday, about opportunities in municipal bonds, misstated the total value of the muni bond market. It is $2.9 trillion, not billion.

Article source: http://feeds.nytimes.com/click.phdo?i=c4e133fe85a438de4b4ec32c8e3e4e64

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