Beaten-Down Munis May Offer Some Bargains

By ROBERT D. HERSHEY Jr.

BARGAIN hunters have swooped in to strengthen the municipal bond market after a major skid between mid-November and mid-January. But specialists say they think the prospects are still bright for income-seeking investors.

“This is the cheapest high-quality fixed-income asset sector out there today,” said Christopher W. Alwine, director of the municipal bond group at Vanguard.

  Because munis are generally exempt from federal taxes, and often from state taxes, they can be attractive even when their yields are lower than those of taxable bonds. But at the end of the first quarter, most yields equaled or exceeded those for taxable Treasuries of comparable maturity, a highly unusual situation.

For example, a double-A rated, 5 percent sewer revenue bond of Allegheny County, Pa., due in 2020 recently traded at a price to yield a tax-free 5 1/8 percent; that’s equivalent to  a taxable 7.1 percent for someone in the 28 percent bracket and 7.9 percent for one in the 35 percent bracket. That compares with a taxable yield of 3 1/2 percent for a Treasury bond of similar maturity, albeit a notch higher quality.

Several factors converged recently to cause an exodus from municipal bonds, and a subsequent buying opportunity. One was the federal legislation extending income tax cuts, which made tax-free bonds less appealing. Another was a flood of new issues in anticipation of the Dec. 31 end of the government-subsidized Build America Bonds program. And a third factor was a rating downgrade of bonds backed by revenue from legal settlements with tobacco companies.

Then there were all the news-media accounts of state budget crises, and fears that some governments might default on their bonds because of public employee pension obligations. In January, Meredith Whitney, an independent analyst, predicted muni bond defaults totaling “hundreds of billions of dollars.”

For 21 consecutive weeks, investors have cashed in more shares of municipal bond funds than they have bought, in many cases a seemingly knee-jerk response to headlines about public-sector financial distress.

And worries about repayments continue, even though defaults last year were only one-third the average from 2008-2009.

“Continued media attention has led many investors to be concerned about the prospects for municipal bonds,” stated a first-quarter Vanguard analysis titled “California Is Not Greece.”

“We believe the doomsday headlines overreach reality,” it said. “The expectation of systemic defaults among state and local government is hyperbole.”

This is the predominant industry view, with specialists pointing to a historically minuscule default rate among municipal issuers.

“I can’t think of a single general obligation bond issue that’s failed to pay principal and interest in the last 50 years,” said Wilson White, whose New York firm specializes in muni bond matters.

Bond issuers’ debt burdens appear low enough that their taxpayers should be able to support them with their personal income and property taxes, specialists said. They also note that tax receipts are now on the upswing and that municipals have relatively long average maturities.

In addition, a default carries enormous stigma and penalties. “Choosing not to make debt service payments would typically have a minimal economic benefit to the bond issuer over the short run but would have devastating long-term results by making future financings extremely difficult,” according to the Vanguard report, written by Mr. Alwine and two colleagues.

Rising interest rates, which tend to depress bond prices, remain a worry. Some advisers are leaning more toward individual bonds rather than mutual funds to avoid losses of portfolio principal if one  should have to sell.  “There is no fixed maturity date” with funds, noted James A. Klotz, president of FMSbonds, a municipal bond dealer in Boca Raton, Fla., meaning that fund investors have no option of holding bonds until they come due and thus obtain full payment.

But for adequate diversification, you need an array of issuers and maturities. Unless you have a few hundred thousand dollars to invest, Mr. White advised, you may wish to stick with funds. But if you have that much money or more at your disposal, he added, “Then you can start picking your own.”

You might also consider exchange-traded funds, which are generally diversified and have low fees and excellent liquidity. One popular E.T.F. is the $1.95 billion iShares S.& P. National AMT-Free Municipal Bond fund, with 1,200 holdings of mostly high quality. Some 42 percent of the holdings have maturities of 5 to 10 years, and its annual expenses are one-quarter of 1 percent. (The biggest concentrations of issues are in California, at 23.3 percent, and New York, at 18.1 percent.)

AS with any investment, of course, homework is essential.  Check bond ratings and keep an eye peeled  for threats to any borrower’s ability to service its debt — a large factory closing in a small city, for example.

Mitchel Schlesinger, managing director of FBB Capital Partners, an investment adviser in Bethesda, Md., said he would avoid even some general obligation bonds, backed by theoretically unlimited taxing power, if those bonds are from distressed areas. Although inflation is an enemy of bonds in general, bonds financing projects supported by dedicated revenue, like those for sewers or bridges, can benefit from it. That’s because utility rates or tolls  may be easier to increase than property or income taxes. 

And while these so-called revenue bonds have traditionally tended to be somewhat less secure  than general obligation bonds backed by taxing power, many professionals have begun to favor them, at least those of high quality.

“We do have a preference for essential-service revenues,” which are immune to political processes, said Mr. Alwine, whose $28 billion Vanguard Intermediate Term Tax-Exempt bond fund is the industry’s largest.

Looking at the overall environment, Mr. White concluded that “it’s a wonderful time to buy munis.” 

“Embrace the headline risk” of battles between public employees and budget-cutting governments, he said. "That’s where you find reward.”