September 1, 2010

Investing: Investing in municipal Bonds Has the Landscape Changed?

By the Investment Strategies Committee

Municipal bonds are an important part of investment portfolios for those reaching retirement age. How do the recent financial crises and fiscal challenges for local governments affect the role of municipal bonds in retirement portfolios? Michael F. Ginestro, senior fixed income portfolio analyst, and Laura L. Milner, senior investment manager, with Wells Fargo Private Bank, respond to questions posed by William D. Sherman, a member of the SLD Investment Strategies Committee.

William D. Sherman: Mike, please review the role municipal bonds play in diversification of investments.

Michael F. Ginestro: During the recent financial crises investors who diversified their portfolios did better than those whose holdings were concentrated. Municipal bonds have always been considered to be an important component in diversifying a tax-sensitive portfolio.

WDS: Laura, what role should municipal bonds play in a fixed-income portfolio?

Laura L. Milner: You don’t need municipal bonds unless you are paying taxes. Know your tax bracket. Compare after-tax yields or taxable equivalent yields to other fixed-income sectors to make sure you are investing appropriately. Those nearing retirement should recognize that they most likely are still going to be paying taxes and a significant portion of that income may be at a high marginal rate.

WDS: Do seniors often think that their tax rate is going to be lower when they retire?

LLM: People do underestimate what their marginal tax rate will be in retirement. They also often ignore their domicile for tax purposes. That can significantly affect their marginal tax rate and the attractiveness of municipal bonds.

WDS: Laura what are single-, double-, and triple-tax- exempt municipal bonds and why are they important, depending upon where one is domiciled?

LLM: Double-tax-exempt bonds are bonds that are exempt from both state and federal income tax. Triple- tax-exempt bonds are bonds exempt from city, state, and federal income tax. Single-tax-exempt bonds are exempt from federal tax but subject to state tax.

WDS: Mike, talk about government deficits and their impact on the risk profile of municipal bonds.

MFG: A big near-term challenge is the severe decline in state and local tax revenues. This creates budget problems requiring cuts in expenditures. Despite the recent revenue challenges, we are seeing signs of local tax revenues starting to stabilize. But I wouldn’t get too optimistic. Until employment starts to improve, we expect minimal tax revenue growth with state and local revenues remaining at the prerecession levels of 2006.

WDS: Are there other challenges not being addressed by budget balancing?

MFG: Yes. Unlike the federal government, state and local governments are required to balance their budgets. These budget-balancing problems are exacerbated by pension and other post-employment benefit programs, which count for an ever-larger share of these budgets. Many pension programs have been underfunded for years even while benefits have continued to expand. That, coupled with falling investment returns and lower contribution rates, has made funded ratios lower which has increased challenges in budget balancing efforts.

WDS: Do these deficits and budget challenges make municipal bonds riskier?

MFG: Yes. This mandates an increasingly important role for strong credit analysis, especially since the insured bonds that currently come to market make up less than 10% of the entire municipal market. This compares to the prerecession era when bond insurance made up more than 50% of the market.

WDS: Is it important to test revenue projections supporting municipal bonds?

MFG: Absolutely! Deals we buy must meet certain internal credit quality thresholds and go through a rigorous analysis by a team of research professionals who preapprove the bonds. We have experts in various municipal sectors including state and local governments, water and sewer, health care, land secured, transportation, and private and public higher education.

WDS: What different roles do outside rating agencies now play?

MFG: In April 2010 Moody’s and Fitch recalibrated their municipal ratings to the higher corporate bond scale. We are seeing many bonds previously with Baa1 ratings that got their ratings adjusted upward by as much as two to three notches. The new ratings scale is designed to reflect a “probability of default.” The historical ratings scale reflected a “distance to stress.” The new scale may actually postpone identifying “stress.” In our view, the new ratings create more comparability challenges across the municipal market, which has become more complex.

WDS: You obviously don’t take a great deal of comfort in the ratings reform.

MFG: That’s right. The recalibration is more pronounced in Baa1 rated bonds. Before recalibration, 21% of general obligation bonds were rated Baa1 by Moody’s. Post-recalibration they amount to less than 2%. As a result, the new recalibrated ratings are essentially masking the underlying credit quality of the issuers.

WDS: But in the Great Depression the number of municipal defaults was minimal.

MFG: That is true, but today’s market is different and much more complex. We are seeing isolated situations play out. Some of these include the City of Chowchilla, California, which citing tough economic times, recently decided not to appropriate fiscal 2011 lease payments that back a $5.9 million Chowchilla lease revenue bond. While the City of Vallejo, California, has not defaulted nor missed any debt service payments on its general obligation debt, the city did miss a lease payment involving its certificates of participation. We’ve seen other examples as well, including the City of Harrisburg, Pennsylvania, which announced that it would miss a general obligation debt service payment to bondholders.

WDS: What other issues should people should be aware of in deciding how municipal bonds fit into their diversified retirement portfolios?

MFG: First, when you talk about diversification, you should diversify both in and outside your state. Second, it is important to diversify across different municipal sectors. Third, you should consider the safety of different types of structures including general obligations, revenues bonds, certificates of participation, and other forms of lease revenues financings. For example, in California, general obligations are voter approved and are typically backed by an unlimited property tax pledge. This means that if the municipality cannot make a debt service payment it can be forced to raise the property tax rate by an unlimited amount to service the debt on the bonds. In many states, like Texas, bond holders do not always have that protection because there are limits on municipalities increasing their property taxes. Other types of structures include various types of tax-exempt leases, often involving the sale of certificates of participation (COPs).

WDS: Just what are COPs?

MFG: COPs are securities that have an undivided fractional interest in an underlying lease. In other words, a COP entitles its owner to a proportionate share of lease payments made by a municipality. COPs are exempt from voter approval and serve as an alternative to issuing municipal bonds A COP credit risk is greater because COPs are backed only by budget appropriations, not by a property tax pledge. It’s critical to have seasoned research analysts on staff to assess this type of risk.

WDS: Are you recommending buying COPs right now, given the economic climate?

MFG: We do approve some types of COPs, but it depends on the essentiality of the project being financed, the credit quality of the municipality, and other types of legal risks that we assess. We are typically recommending general obligation, essential service, or sales-tax- pledged bonds, which are typically secured by much stronger revenue streams.

WDS: Laura, how will expected increases in personal income tax rates and new Medicare taxes affect the demand for municipal bonds?

LLM: Municipal bonds should be in increasing demand as one of the few remaining tax shelters. In addition, they are typically not subject to the alternative minimum tax.

WDS: Discuss the difference between investing in a municipal bond fund and investing in individual bonds using an investment advisor.

LLM: Municipal bond funds have their place, especially for smaller investors who can’t diversify a portfolio. But you’ve got to know what you’re buying. Funds may hold bonds that investors would never own individually. In addition, many municipal mutual funds invest up to 20% of their assets in bonds subject to alternative minimum tax.

WDS: When does it pay to use an investment advisor, and what are the fees?

LLM: A mutual fund with a sales load could charge as much as 4%–5% up front. So-called no-load funds still charge management fees that can add up to 1%–2%. Our fee for a fiduciary relationship begins at 45 basis points for a $2 million portfolio.

WDS: Finally, what’s your outlook for the municipal market?

LLM: Strong technicals are going to win out over weaker fundamentals. The municipal market is technically oriented, meaning it’s driven by supply and demand. Recently, there has been more demand and less supply, and therefore, despite all the negative headlines and concerns about municipal budgets, municipal bonds are still performing pretty well. The outlook is good because overall demand will increase as people realize they’re going to be paying higher taxes.

WDS: Mike and Laura, thank you for your insight into this often confusing and opaque area of investing.