MuniLand

Muni exchange traded funds

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A small but growing corner of muniland consists of municipal bond exchange traded funds (ETFs). I know very little about these products and asked Matt Tucker, a managing director on BlackRock’s fixed income portfolio management team, to write a short introduction to the product.

ETFs: The new way to access the municipal bond market

Traditionally, the only two options available for those who wanted to invest in the municipal bond market were through mutual funds or laddered bond portfolios. In the past five years, though, exchange traded funds (ETFs) have come on to the scene. They provide a combination of diversification, index performance and exchange liquidity, making them a compelling addition to anyone’s municipal bond investments.

Like other funds in the market, ETFs offer diversification, a challenge to achieve for individual bondholders. Bonds generally trade in lots of 10,000 par or more, making it difficult for all but the wealthiest investors to build good, diversified portfolios. The share of the muni market that was AAA-rated fell from 70 percent in 2007 to 15 percent today, as a result of the demise of the bond insurance companies over the past few years. As a result, there is much more default risk in the current market. Muni ETFs generally hold hundreds of positions, and shares of the ETF can be obtained for the price of a single share of a single fund, often as low as $50. Like individual bonds, the holdings are visible, meaning that most ETF providers allow investors to see fund holdings on a daily basis. This provides investors with the comfort of knowing what they own.

In terms of performance, the majority of municipal bond ETFs in the market are index funds. According to a Standard & Poor’s study released at year-end 2011 that examines the performance of active funds, 90 percent of national municipal bond funds underperformed their benchmarks over the past five years. Index ETFs are generally not the highest-performing funds in a given period, but they have also not been the lowest. This can make them a compelling alternative for investors looking for more consistent performance in their municipal bond portfolio.

A smarter way for Congress to talk about muni tax code

Chris Mauro, head of U.S. municipal strategy at RBC Capital Markets, sent around a comment note suggesting that the media coverage of the Senate Finance Committee hearing Wednesday that included discussion of possible changes to the taxation of municipal bonds was overheated:

Yesterday, the Senate Finance Committee held a hearing entitled “Tax Reform: What It Means for State and Local Tax and Fiscal Policy”. A simple reading of the media accounts of this hearing would lead one to believe that the entire event was dedicated to a detailed discussion of the future of the tax-exempt status of municipal bond interest. So we decided to review the tape of the hearing in order to see what in fact was discussed. In reality, the vast majority of the hearing was focused on two issues – the deductibility of state and local taxes by federal taxpayers and the ability of state and local governments to collect sales taxes on internet and catalog purchases.

Both Committee Chairman Max Baucus and Ranking Member Orrin Hatch made some passing comments about tax-exempt bonds and the federally subsidized taxable Build America Bond (BABs) program, with Baucus making generally positive statements about BABs and Hatch making generally negative ones. Senator Maria Cantwell of Washington State expressed some concern about the importance of tax-exempt bond financing to public power utilities in the northwest, but beyond that, there wasn’t a whole lot of discussion about the muni tax exemption.

Does the market trust corporate issuers more?

Darrell Preston of Bloomberg News wrote a great piece comparing the yields on trades of comparably rated corporate and municipal bonds. He highlighted that corporate bonds have a much higher risk of default than municipal bonds but have similar yields. His analysis suggests that risk is not being properly priced if in fact ratings between asset classes are comparable and that municipal issuers are paying interest rates that are too high.

Two years after Moody’s Investors Service and Fitch Ratings changed standards to put municipal credits on the same footing as corporates, California and Illinois are among states that still pay more for debt than similarly or lower-rated corporations, according to data compiled by Bloomberg. Yet Moody’s says companies default at 86 times the municipal rate.

“Taxpayers continue to get a raw deal,” said Tom Dresslar, spokesman for California Treasurer Bill Lockyer, who pressed for the rating changes. “Not much has changed.”

Municipal bonds don’t always have the best after tax returns

The following is from guest commentator Terry Hults, Senior Portfolio Manager of Municipal Investments, at AllianceBernstein. It’s helpful to see municipal bond investing in a broader light and the data above really frames the discussion well.

Municipal bonds have an after-tax yield edge over Treasuries, corporates and other taxable bonds most of the time—but not always, as the display above  shows. Opportunities are driven by sector supply and demand, credit-quality trends, volatility, and changes in tax law. Treasuries did best in 2007 and 2008, corporates did best in 2009, and mortgages did best in 2010.

Adding a judicious allocation to these taxable sectors during those years would have meaningfully added to the returns of a tax-aware portfolio. Today, low interest rates and the fear of future rate increases have driven some bond investors into shorter bonds and cash. But an investment strategy that considers municipal and taxable bonds across the full credit spectrum provides greater ability to pursue return without taking undue risk.

Boston funds publicly, while Chicago goes private

Two major American cities are embarking on large capital programs, but in very different ways. Boston Mayor Thomas Menino has a $1.8 billion, five-year plan that he will fund with municipal bonds, while Chicago Mayor Rahm Emanuel is trying to push a $7 billion plan, which will be paid for by private investors, through the city council. It would be hard to find to two more dissimilar approaches to rebuilding America’s urban infrastructure or two more different lists of who will reap the monetary benefit of the improvements.

Boston approaches its infrastructure needs with a rolling five-year schedule of projects that is updated on an annual basis. This allows for more controlled expensing and planning. In contrast, Chicago’s Emanuel announced his infrastructure privatization plan in January with very few details and buy-in only from the private investors who will benefit from their involvement. The Chicago proposal gives control of infrastructure decisions to a panel of four private citizens and one city council member with no ability for the city council to have oversight on projects and contracts. Chicago has a terrible history of leaving taxpayer money on the table in its privatization efforts. In 2008 the city’s parking meters were leased out to private investors for a tiny sum:

Chicago drivers will pay a Morgan Stanley-led partnership at least $11.6 billion to park at city meters over the next 75 years, 10 times what Mayor Richard Daley got when he leased the system to investors in 2008.

The Marlins’ new home, courtesy of taxpayers

Kevin Grey of Reuters wrote a delightful piece describing the opening of the the new home of the Miami Marlins. The stadium has all the touristy bells and whistles that you would expect from a state that brought us Walt Disney World, Universal Studios and Sea World:

When baseball’s Opening Day kicks off next week, the Miami Marlins will inaugurate a new $515 million ballpark built with all the trappings of South Florida – two enormous fish tanks, palm trees and a kitschy (of course) home run celebration display.

With all its fancy trappings, the Marlins’ new stadium could very well set the national standard for family-friendly sports destinations. But after the opening-day fireworks dissipate, it will become clear that the ballpark sets a low bar for public diligence and oversight and that it could result in an SEC sanction (or worse) for some local public officials.

Muniland’s bad boys

Last week I called Puerto Rico “America’s Greece” partly because of its financial statistics and partly because of its inclusion in the muniland bad-boy list maintained by Thomson Reuters Municipal Market Data. What the bad-boy list tells us is how much the bonds of the weakest issuers trade over the AAA benchmark. To put it another way, that difference is the premium the market charges for the risk of owning these bonds; it also reflects the premium the bad-boy issuers would have to pay to bring new bonds to market. For example, Puerto Rico, currently the weakest borrower on the list, would have to pay 225 basis points more than a AAA 10-year bond to borrow. Given that MMD AAA benchmark closed on Tuesday at 2.33 percent, that would mean an investor would demand a yield of 4.58 percent to buy a 10-year Puerto Rico general obligation bond. Also using Tuesday’s numbers, investors would demand a yield of 3.88 percent to own a 10-year California GO bond. This is how the market works — it punishes the weak.

Studying the chart above and table below you get a sense of the relationship between credit quality and the interest surcharge. The weaker the credit quality — that is, the lower the number or rating — the higher the interest paid. There are other factors that affect the premium, including the tax rates in the state (higher-taxed and wealthier states have lots of demand from their citizens for tax-exempt municipal bonds) and the recent supply of new bonds in the state. But the fundamental bond market truism remains: The riskier you are, the higher the interest rate you pay. In muniland these are the bad boys. Issuer Spread S&P rating Moody’s rating Debt & unfunded pensions Puerto Rico 225 BBB (6) Baa1 (6.5) $ 64 B Illinois 155 A+ (8) A2 (9) $ 86 B California 90 A- (7) A1 (8) $ 137 B Nevada 65 AA (9) Aa2 (9) $ 4 B Rhode Island 55 AA (9) Aa2 (9) $ 6 B Michigan 53 AA- (8.5) Aa2 (9) $ 19 B D.C. 43 A+ (8) Aa2 (9) $ 6 B New York City 43 AA (9) Aa2 (9) $ 161 B Ohio 35 AA+ (9.5) Aa1 (9.5) $ 14 B New Jersey 30 AA- (8.5) Aa3 (8.5) $ 60  B

Source: Municipal MarketData, Moody’s Investors Service, Standard & Poor’s Ratings Services, local government budget reports, official statements.

The SEC’s startling refresher on due diligence

The SEC’s Office of Compliance Inspections and Examinations, muniland’s uber-regulator, issued a “Risk Alert” yesterday directed at underwriters of municipal bond offerings. The alert basically said: If you offer new bonds for sale, you must perform due diligence on the issuer. And you better document what you did.

I have to wonder about all the sudden fuss. The SEC’s “Risk Alert” was just restating a fundamental law in securities markets that requires securities dealers to investigate and verify what they are offering to investors. In other words, dealers must know their product, because there is no immunity for selling bad stuff. It’s a little shocking that the SEC has to remind securities dealers that they are required to do due diligence, but they went further and detailed some specifics on what had to be done (Page 3, emphasis mine):

the Commission also stated that sole reliance on an issuer will not suffice in meeting an underwriter’s “reasonable basis” obligations.

The birds’-eye view of muniland

My Thomson Reuters colleague at Municipal Market Data, Daniel Berger, published an excellent report on the debt of the 40 poorest U.S. cities. His work is exclusively for MMD subscribers, but I excerpted the high-level part where he summarizes the general view the credit rating agencies have about municipalities. Here is what Dan had to say:

Moody’s

According to a recent report from Moody’s, the outlook for various… local governments remains negative. It cited a weak national economy and possible global risks to stock markets that could hurt state revenue. Another problem is the austerity measures of the federal government, which diminish any chance of more stimulus aid. This week Moody’s released the results of a default study of municipal bond issuers using default data from 1970 through 2011. They believe that revenue bonds will account for most of the troubled issuers and they foresee a “very small but growing number” of local government issuers defaulting on their debt.

Fitch

Fitch has no single outlook for the local governments. However, localities face two big concerns. First, Fitch expects an inflation-adjusted 13% decline in property values. Taken together with the fact that assessments are catching up with previous declines, Fitch expects further declines in property tax revenues for local governments. These declines may pressure some local bonds.

An open letter to Puerto Rico Governor Fortuño

Dear Governor Fortuño:

I wanted to write you to discuss the condition of Puerto Rico’s economy and its municipal debt load. After I wrote a column last week entitled “Puerto Rico is America’s Greece,” I was surprised to see the piece get a lot of attention. What I said has been common knowledge in the U.S. bond market for some time, and the facts that I brought up have been previously pointed out by the major credit rating agencies. For those in municipal bond markets, I wasn’t really adding much that was new to the conversation.

But it turned out the attention my piece was getting was from people outside the bond market. Those who were responding to it were those who love Puerto Rico and are concerned about its future, namely its citizens. They seized on what I wrote and passed it around on Facebook. Newspapers like elnuevodia.com and blogs picked it up and debated the fine points of the island’s unemployment rate and deficit spending. I’ve never seen anything like it in the United States.

Now, before going any further I need to mention that I made one mistake in that piece, which I did not discover until I read the rating agencies’ reports about the commonwealth. Your constitution requires that bond principal and interest be repaid before your government can make any other expenditures. That means bond repayments take precedence over payments for education, healthcare, government-worker wages and pensions. Bond markets cheer for this, of course, but I’m not sure that your citizens are entirely aware of it. Michael Corkery of the Wall Street Journal also wrote about your bond offering last week and didn’t mention the seniority of payments that makes your debt so appealing to investors.

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