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What to Approach, What to Avoid in Munis

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm joined today by Dave Sekera. He's a bond strategist here at Morningstar, and he is here to take a look at how outflows from muni bond funds have impacted the municipal market and if it's created any opportunities for individual investors.

Dave, thanks for joining me today.

Dave Sekera: You're welcome. Good to be here.

Glaser: Could we start off with just a general overview of the muni market? How big is this market, how many issuers are there, what are some of the key facts people should be aware of?

Sekera: Sure. One thing about the municipal market that I think a lot of people don't realize is just the size of the market. It is about $3 trillion in debt outstanding across all of the different municipalities in the United States, and there are just tens of thousands of different individual municipal issuers out there, most of which probably have less than $100 million of debt outstanding.

So when we compare it to the size of the corporate bond market, it is smaller in a nominal amount, but the corporate bond markets only probably has several thousand issuers outstanding. Those individual issuers typically have a larger amount of debt outstanding each.

Glaser: So that's pretty different from corporate bond markets.

Sekera: Right, and so that's part of the dynamics that we're seeing going on right now, so in the corporate bond market, as an analyst, I can cover 50 or 60 different credits, whereas in municipal bond market there are just so much more individual credits outstanding, and you need to do the same kind of due diligence on it. I think that's causing some of the technicals we're seeing in the market right now, as they just aren't enough buyers out there to handle all the volume of supply that is coming out.

Glaser: So certainly with fallen prices we've seen over the past couple of months in munis, and some hand ringing about defaults, and [fears] that there are going to be mass defaults. What does that look like in terms of the credit quality of munis for the last couple of years?

Sekera: In the last couple of years, we definitely have seen tax revenues across the board go down, and that has impacted their cash flows and has impacted their credit metrics.

However I would say, based on their own internal GDP forecast for this year, Bob Johnson, our director of economic analysis, is looking for 4% GDP growth, and that should help balance the revenues that are coming in, and in fact we have seen some slight increases in tax revenues coming in.

Glaser: Even before these more tax revenues, were we seeing a huge wave of defaults in the municipal space?

Sekera: No, we weren't seeing a huge wave of default, and in fact I've got some statistics here for you. So reportedly over the last 39 years, there have only been 54 bond defaults in the municipal bond market. Three quarters of those defaults have really been concentrated in the stand-alone housing bonds and some of the health-care bonds out there, and really only a few of them were general obligation bonds.

Glaser: So it sounds like defaults haven't been a huge problem, that revenues are going up. Why is there so much concern in the marketplace, then? Why do we hear so much from individual investors and from others that the municipal market is really in trouble?

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Sekera: We have what I call media-induced panic right now. There have been analysts out there who have been calling for just a significant increase in the default rate this year and for a huge amount of defaulted issuance. So, for example, I believe some people have been calling for call it 50 to 100 issuers to default this year, which they believe could be in the hundreds of billions of dollars.

To put that in context, last year, there was only $2.7 billion worth of defaults, and in 2008, one of the highest years, was only $8.5 billion worth of defaults. So if we really were to have call it $300 billion of defaults this year, considering it's a $3 trillion market, it's about a 10% default rate, which would actually equate to some of the worst years that we ever saw in the high-yield corporate bond market.

Glaser: So what's been the impact of this media-induced panic then?

Sekera: I've got some numbers for you on that, too. So we've seen now 14 straight weeks of net outflows in the municipal bond mutual funds. So from November through January, according to Morningstar statistics, we've seen $33.4 billion of net outflows.

Now to put that into context, through the prior record of $14 billion, which was from September '08 through December '08, which is at the heart of the credit crisis, now we've more than doubled the amount of cash that's come out of that market. So just based on the technicals in the market, we've seen a lot of portfolio managers who have to raise cash to cover redemptions.

Now, of course, there is so much supply out there, as all these portfolio managers are trying to sell bonds at once. They are now selling the bonds that they can sell, not necessarily the bonds that they want to sell. So they are selling the more highly liquid names, which are usually the better credit quality.

Glaser: Has this created any opportunities in the municipal space then?

Sekera: It has. So essentially about two-thirds of the municipal bond market is owned by individuals whether individual bonds that they own themselves, through mutual funds, managed accounts, and so forth. So we don't really necessarily have the same kind of institutional investor base that we do have in the corporate bond market that can essentially take a lot of that supply when it comes to market.

Glaser: Now you said that many of these bonds are owned by individuals, but should they just go out and buy any municipal bond right now, is everything cheap or is there really more of a process to that?

Sekera: Of course, we always recommend individuals do need to do their own due diligence, but we do see this as being a very attractive buying opportunity.

So in fact, we've seen a lot of municipal bonds out there where the all-in yield is actually trading equivalent to or even slightly higher than the yield that we may saw in the taxable corporate bond market. So you're picking up the tax-exempt nature of the municipal bond essentially for free for the same kind of credit risk that we're seeing in the corporate bond market.

Glaser: What are some of the due diligence that an individual should go through before they buy an individual bond?

Sekera: So as far as due diligence goes, first thing in the municipal bond market right now is when you start looking through the individual offerings, just pick out the ones that you know you don't even want to spend your time on. So, first of all, anything that's non-rated, I wouldn't bother taking a look at for an individual investor.

Second stay away from anything that I'd call a high risk or non-essential public service. So, for example, a lot of co-generation electric power plant facilities, I would stay away from. Those who are usually typically more project financing, and we've seen higher-than-standard default rates in those types of issuers.

Thirdly, I would just stay away from the ones that are currently in the headlines that we all do know have additional credit risk. Unfortunately State of Illinois, State of California, not that I think that there is a real potential for them to default in the near term, but I do think there could be a lot of volatility in the spreads for those kind of names.

Then lastly, stay away from the ones that we've seen, the historically high default rates. So the housing bonds that we mentioned earlier, some of the health-care names, especially some of the ones that are really relying upon Medicare, Medicaid reimbursements, such as critical care, retirement communities, those I would stay away from as well.

Another word of caution that I would note to investors is, a lot of bonds do have what they call municipal bond insurance, so companies such as MBIA, Ambac, FGIC and so forth, had a business where they used to essentially insure the municipal bonds. Back in the day, they had AAA ratings. Of course this is all before the credit crisis. I think Ambac may be in receivership now; MBIA I believe their ratings are below investment grade.

So, I personally wouldn't put too much weight on the bond insurance, and really as part of your due diligence, you need to look through the bond insurance and look to the ultimate guarantor or the ultimate credit counterparty for the individual bonds.

Glaser: So, which bonds do you think would be the most attractive?

Sekera: Well, first of all general obligation bonds. A general obligation bond does have the full faith and taxing support of the municipal entity there. So just take a look. Unfortunately, they don't have the same financial transparency as we do for the corporate bond market, but you can get at least their annual statements, they're called a CAFR. That stands for the comprehensive annual financial report, and you can get a pretty good idea of the strength of the municipality by going through that, and then also make sure that there aren't too many large unfunded pension obligations that the municipality is on the hook for.

Second, look for the necessities out there, for example, the water and sewer revenue bonds. For essential public services, I think you're going to be relatively safe with those going forward as well.

Thirdly, my own favorite right now are the corporate-backed municipal bonds. So there are what they call IDRs and PCRs, which are industrial development revenue bonds and pollution control revenue bonds, where the municipal entity is really more of just a conduit, so it's a pass-through entity, in which the ultimate obligor of the bonds is a corporation, and a lot of utilities use these, a lot of energy companies use these bonds.

So often you have a BBB or A corporate entities who are backing up these bonds, and if you can buy those at the same yield or even slightly higher due to the technicals in the market, I think that's very attractive right now.

Glaser: Then finally, if all of these terms and due diligence seem to be overwhelming, is there anything wrong with a managed product like a mutual fund for investing in the municipal space?

Sekera: So for investors that do want to take advantage of this opportunity, they don't have the time or wherewithal themselves to go out and do due diligence on individual bonds themselves. There are a plenty of products that we have here at Morningstar in order to look through for mutual funds, ETFs, and be able to analyze those, and see which is appropriate for their own accounts.

Glaser: Dave, thanks so much for joining me today.

Sekera: For Morningstar, I'm Jeremy Glaser.