State of the Muni Market
The municipal bond market’s perceived troubles continue to garner attention from the media, with one of the most recent scares coming from a recent 60 Minutes story. The segment included an interview with Meredith Whitney, a banking analyst who prophesizes that there will be between 50 and 100 significant municipal bond defaults in 2011, totaling hundreds of billions of dollars.
Since the December 19th broadcast, the story has understandably caused some concern among clients regarding their exposure to the municipal bond market and the potential of large scale defaults. So let us clearly state that, despite the tone of this report and the obvious financial challenges ahead for governments of all levels, a well-diversified, high-quality municipal bond portfolio remains suitable for high-income taxable investors.
Because yields from municipal bonds are generally exempt from federal personal income tax, municipal bonds provide an attractive alternative to U.S. Treasury bonds for investors in a relatively high tax-bracket. In a normal environment, this tax advantage is reflected in municipal bonds offering lower yields than Treasuries. However, in the current market, yields for many municipal bonds have risen above the yields of comparable Treasury bonds – this simply amplifies the after-tax yield advantage of muni bonds.
While Whitney may attribute the higher yields (which correspond to lower prices on existing bonds) to the credit risk of the issuing states and municipalities, others disagree. “Supply and demand, higher Treasury yields, and psychological factors combined to drive up muni yields. These changes were not related to credit risk concerns for munis,” stated Mathew Kiselak, co-manager of Vanguard Long-Term Tax-Exempt Fund.
Historical figures help put in perspective the stability of the municipal bond market. Among the 18,400 municipal bonds rated by Moody’s Investors Service during the 40 years from 1970 to 2009 – a period that includes 5 recessions – only 54 issuers defaulted. This equates to a default rate of 0.3%. And default does not connote a value of zero – of the 54 that defaulted, the average historical 30-day post-default trading price for the bonds is $59.51 relative to a par of $100, implying close to a 60% recovery rate on capital following default.
There are a few major reasons why the default of a state or municipality is so rare. As stated in a report issued by Fitch Ratings in November, “Debt service is generally less than 10 percent of a state or local government’s budget, and in many cases much less.” Given that a default on its debt would do little to clear up budget problems, doing so doesn’t make much sense – particularly in light of the fact that defaulting could significantly increase the cost of issuing future debt (i.e., investors would demand higher interest rates before lending to a borrower which has previously defaulted).
In spite of the recent news, investors should recall that the primary objective of any fixed income security in a diversified portfolio is to bring stability to the portfolio. For this reason, both our taxable and tax-exempt fixed income recommendations are centered in short- to intermediate-term high-quality bonds. While there can be no question that several state and local governments are facing major budgetary problems, we remain comfortable with high-quality municipal bonds and consider the alarming media chatter around large scale defaults to be exaggerated and misleading.