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Municipal Bonds Are Looking Cheap

A number of technical factors in the municipal bond market have magnified the selling pressure.

Dave Sekera, 02/22/2011

The head trader of one Wall Street credit desk likened last week's corporate bond market to the movie Groundhog Day. Just as Bill Murray's character was stuck living the same day over and over, credit spreads relentlessly ground tighter, and the supply of paper in secondary trading declined day in and day out.

The demand from corporate bond fixed-income funds appeared to be insatiable, as investors continued to reallocate their fixed-income investments from tax-exempt municipal bonds to taxable corporate bonds. New issues in the corporate bond market were generally well received, but demand for paper has reduced the typical new issue concession to zero. In fact, some new issues were priced tighter than the same firm's existing bonds. This forced the spreads of the existing bonds tighter. However, not everything fared quite as well in the new issue market. A few deals were priced so tight that the issue immediately traded wide of the new issue spread.

Municipal Bonds Looking Very Cheap
A number of technical factors in the municipal bond market have magnified the selling pressure and resulted in significant spread widening. About two thirds of municipal bonds are held directly by retail investors or through mutual funds, so in the face of current selling pressure, there is not a deep enough bench of institutional investors to pick up the slack. Municipal bond mutual funds have experienced a total of $33.4 billion of net redemptions from November 2010 through January 2011, and the exodus has continued throughout February. This compares with the prior record of net outflows in the heart of the credit crisis of $14 billion from September 2008 through December 2008. The panic in the municipal market began last November and has continued to be fed by the media and analysts who have prognosticated that there could be 50-100 municipal defaults this year totaling hundreds of billions of dollars.

A significant portion of municipal bonds were insured by bond insurance companies, which had the effect of turning municipal bonds into a commodity-oriented product. In the past, an investor could purchase an AAA rated municipal bond based solely on the strength of its insurance. However, thanks to the credit crisis, these insurance companies have lost their AAA ratings. In fact, most of the firms that provided insurance on municipal bonds are now rated below investment grade. This requires investors to conduct due diligence on the municipal entity itself, and many institutional investors do not have the resources or staff to increase the amount of research they can conduct. Considering there are tens of thousands of municipal issuers, typically with less than $100 million of debt outstanding, there aren't enough analysts around to analyze all of the bonds for sale. This has led to a significant amount of widening in the market as sellers need to reduce their offers to attract the attention of the few buyers. To raise cash to cover redemptions, portfolio managers are finding that they are only able to sell what they can (typically higher quality), and not what they want to (lower quality).

While we understand that the recession and lackluster recovery have pressured tax revenue and budgets, it seems unlikely to us that the forecast for hundreds of billions of defaults is reasonable. Considering that the size of the outstanding municipal market is about $3 trillion, $300 billion of defaults would equate to a 10% default rate. At 10%, that would compare with some of the worst years and highest default rates for the junk bond market. Municipal entities have a lot of accounting and budgetary levers they can pull before bankruptcy would be considered. In addition, Morningstar's director of economic analysis, Bob Johnson, expects GDP to increase as much as 4% this year. An increase of that magnitude should provide a tailwind for tax revenue not only to bottom out, but to increase.

For investors wishing to take advantage of this opportunity, we have a few suggestions to begin due diligence. First, stay away from any issuer that isn't rated. That is usually a sign that the issuer would not have the financial strength to earn an investment-grade rating. Second, eliminate any bonds issued by nonessential project financings and high-risk (with historically high default rates) categories such as cogeneration facilities or health-care facilities reliant upon Medicare and Medicaid (such as nursing homes and critical-care retirement centers). We would also take a pass on bonds from the states that are in the headlines for their large budget deficits and unfunded pension obligations (Illinois, California, and so on). We expect these issuers to have greater market volatility and lag the rest of the municipal market when it improves.

The sectors that we find the most attractive include general obligation bonds, bonds issued by essential government services (such as water and sewer bonds), and bonds backed by investment-grade corporations (our favorite). Corporate-backed municipal bonds are often issued by municipal entities that are a financing conduit where the proceeds are used for the public benefit. For example, utilities and energy companies may use this type of financing to purchase coal scrubbers to control pollution. These entities are often referred to as IDRs (industrial development revenue bonds) and PCRs (pollution control revenue bonds).

After whittling down the list of possible candidates, we recommend conducting due diligence on the underlying issuer and not to rely on any bond insurance. For general obligation and water and sewer bonds, you should be able to obtain the issuer's comprehensive annual financial report from the municipality. For the corporate-backed municipal bonds, use Morningstar's corporate bond ratings and credit reports as a starting point.

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