These bonds are issued by American cities and states to finance public services and infrastructure improvements including schools and sports stadiums. They are exempt from federal taxes and are a staple of retail investors’ portfolios; about 35% of the bonds are sold to middle and upper-income individuals, rather than institutions.
But institutions are taking another look at municipal bonds as one of the few strong performers among fixed-income securities amid the dismal prospects after the credit crunch and fears of a recession.
Municipal bonds, or “munis”, are becoming so well-regarded that, instead of suffering because of the troubles that have hit bond insurers, investors and analysts are wondering why strong-performing munis should be insured at all.
Munis are predicted to fly this year because of safety and returns. The yield ratio for 10-year munis in relation to treasuries, or US Government debt, is about 90%, which means the yield from munis is nearly the same as those of Treasury bonds, according to Merrill Lynch.
Munis have an advantage since investors do not have to pay tax on them, as they would on gains from treasuries.
Merrill Lynch fixed-income strategist Martin Mauro cautioned investors that munis are an increasingly attractive alternative to treasuries, as, “the flight to quality that drove the outperformance of treasuries in 2007 also pushed their yields down substantially… treasuries are not likely to outperform in 2008 as they did in 2007”.
Merrill Lynch municipal strategist Philip Fischer said in research last week: “With munis yields hovering around Treasury levels, the flight to quality in treasuries should propel munis returns more this year than last. In fact, the munis market is well set up for an economic slowdown.”
Municipal bonds also have high credit quality, which is important to investors buffeted from multi-billion dollar downgrades to more esoteric securities, such as asset-backed securities and more complex collateralised debt obligations.
Munis also hold a low risk of default since few American cities and states collapse.
The municipal bond market made a record last year with $428bn (€290bn) in issuance, and this year will be another record, according to Municipal Market Advisors, a specialist research firm.
Stephen Davidson, director of research for the Securities Industry and Financial Markets Association, said the high level of activity has come from cities and states looking to take advantage of relatively low interest rates to refund their debt.
Munis have also proved to be resilient against the problems involving big bond insurers, including MBIA. Five of the top nine bond insurers carry negative rating outlooks or warnings, according to Municipal Market Advisors.
Those firms receive about half their business from insuring municipal bonds, and American cities and states paid $2.5bn in premiums to the insurers last year. However, even as bond insurers have taken a beating over their coverage of some sub-prime securities, the scandal has not hurt munis.
Thomas Doe, chief executive of Municipal Market Advisors, said: “Investors have to be attuned that the bond insurance problem has nothing to do with the underlying credit of the municipal bonds.”
Some investors in municipal derivatives are questioning whether bond insurance for munis is necessary, given the high credit quality and low risk of default for the securities.
Munis are rated on a different scale than corporate debt by Moody’s and Standard & Poor’s; if they were rated on the same scale as companies, they would continue to maintain high credit ratings and not need expensive bond insurance, the argument goes. Doe said: “In light of the problems the bond insurers have had, investors are asking why munis are rated on their own scale and why are they not rated on the same scale as corporates.”
Mauro said: “The market has largely removed the cost advantage (lower rates for munis in relation to similar underlying credits) that bond insurance provided issuers.” The yield spread for insured municipal bonds rated Aaa has widened to about 35 basis points compared with uninsured bonds with the same rating.
Many top investment banks mired in sub-prime troubles are also the biggest underwriters of munis. The top underwriter isCitigroup – a legacy from Salomon Smith Barney – followed by UBS. The top 10 also includes Bear Stearns, Goldman Sachs, Lehman Brothers, Bank of America, Merrill Lynch and Morgan Stanley.
While munis are doing well compared with the troubles afflicting other fixed-income securities, they remain subject to some problems.
Davidson said: “Munis are not completely a safe haven for investors; they are like the dim bulb in a dark alleyway.”
