Should You Invest in the Municipal Bond Market?

We all know the saying, “There are only two things that are certain in life – death and taxes.” We could add a second part to that saying; “Because taxes are never going away, there will always be a need for Tax-Exempt investments, otherwise known as Municipal Bonds.”

With so much publicity surrounding the municipal bond market, it’s important that we look closely at this asset class.

Municipalities run their budgets on debt issuance and tax revenues. If a municipality defaulted on one of its bonds, it would be too costly for them to issue future debt as investors would demand a much higher yield to compensate for the additional risk. Therefore, default would have to be an absolute last resort.

State and local governments continue to have revenue shortfalls due to lower tax revenues, and rising costs, primarily from underfunded pension plan and health-care obligations. These budget concerns could be worsened if collections from property taxes drop with declining housing values. Municipalities also may lose the additional federal stimulus which has helped pay for operating costs through the issuance of Build America Bonds in 2010.

In short, municipalities will be challenged to successfully balance their budgets through increases in taxes, decreases in services, and renegotiation of pension and health benefits.

While municipal default risk is a headline possibility, we believe it will be on a very limited basis and limited to issuers with low or no credit rating. Prior to the credit crisis of 2008, 50% of municipal issuance came to market with insurance enhancement compared to only 7% today. Without a rating based on insurance, municipal issues must be evaluated based on their own creditworthiness.

It will be increasingly important to only invest in those municipalities with moderate debt and strong reserves. We will focus on these high quality issuers and on types of issues with projects that have a strong need in the community. These types of issues include general obligation bonds which are repaid with various tax sources of the issuer, issues that hold collateral (usually US Treasury securities) equal to 100% of the maturity amount, and essential service revenue bonds paid from the earnings of the revenue-producing enterprise they are created for such as water, sewer, power, and healthcare.

Municipals currently appear to be attractive relative to taxable bonds, but the premium being paid is due to the additional credit risk of the municipalities. As such, we believe in an investment strategy that offers you a way to gain tax-advantaged yield while taking absolute caution with regard to the credit quality of issues. We also believe that being properly diversified by industry and geography is the best way to protect a risk of a major loss.

We believe that a national municipal bond fund best accomplishes these goals. A state-specific municipal bond fund does not provide adequate diversification in order to insulate you from a negative economic situation in a particular region.

We also believe that a strategy that utilizes individual municipal bonds is not wise at this time. For many asset sizes, it is impossible to achieve adequate diversification with individual, state-specific bonds. There is also the risk of not being able to sell a bond at a reasonable price if you need cash during a period of economic uncertainty.