Municipal bonds are traditionally one of the safest havens in times of economic uncertainty. But lately, investors have been treating them like just another distressed asset class. Less than six months ago, munis may have reached their cheapest levels since just after the Civil War, says Ying Chen Li, muni strategist in JPMorgan Chase's (JPM) fixed-income department. In the latter half of the 1860s, defaults on state government-issued bonds surged not only because of the ravaged economies of the Confederacy but also because of a clause in the 14th Amendment to the U.S. Constitution that prohibited repayment of public debt issued to aid the rebellion against the Union.
In 2008, the subprime crunch has taken its own toll. The Municipal Bond Credit Derivative Index, launched in May, partly in response to the credit crisis, is trading at levels that imply a greater than 30% probability that individual states, such as California, will default on their bonds over the next 10 years, says Ying.
"That just doesn't make sense at all," he says. "There will be some defaults at the local government [level], but at the state level, it's unimaginable."
One measure of how big a bargain muni bonds are: The yield ratio of five-year, triple-A munis to five-year Treasury notes has averaged 80% over the past 10 years, says Ying. But in late February and early March, the ratio topped 150%—that is, the yield on munis was nearly double its normal level. Credit spreads—the yield difference between munis and risk-free U.S. Treasury bonds—have narrowed somewhat since the weeks of heightened nerves that preceded the collapse of Bear Stearns, he says, but not by much. Ying says the yield ratio now is closer to 90%, while the ratio for 30-year, triple-A munis is 105% of 30-year Treasuries, compared with an average of 94% over the past decade.
DOMINO EFFECT
The plunge in muni bond values was prompted mainly by rating agency downgrades of such bond insurers as Ambac Financial Group (ABK) and MBIA (MBI). Their insurance used to guarantee that munis got a triple-A rating—and used to give investors peace of mind about the credit risk they were buying. No more. The insurer downgrades triggered lower ratings for the bonds the companies insured. In turn, the lower ratings on the munis led to forced selling of bonds by institutions not permitted to own debt below a certain rating. The result: a glut of munis on the market at big markdowns.
Munis are always recommended for their evergreen tax advantages, which are expected to increase as the Bush tax cuts expire in 2010 and the top tax rate reverts to 39.6%, no matter which party wins the White House. But the current environment has created new possibilities for investors who aren't easily frightened by less than top-notch credit ratings, especially if they understand that the bond insurers' fall from grace was linked to their coverage of riskier mortgage-backed bonds, not anything related to the muni market.
In the market turmoil—particularly after the auction-rate securities market froze up—"we saw spreads [vs. Treasuries] widen on A and BBB credits, mainly due to supply pressure,"Thalia Meehan, portfolio manager of tax-exempt products at Putnam Investments, wrote in an e-mail message. "We viewed this as an opportunity to [buy higher-yield muni bonds] without taking undue credit risk."
She said her team plans to add bonds opportunistically from issuers with ratings below triple-B, or below investment grade, as they see acceptable credits at attractive prices.
GOING FURTHER OUT
There are also new openings in longer-dated maturities. Before last year's sell-off, Putnam's muni funds had been weighted toward bonds set to mature in 15 to 20 years, due to the extreme flatness in the muni yield curve. But the yield curve has since gotten steeper—to the point that investors now get more yield for longer maturities—which has prompted Meehan and her fellow fund managers to move more into 20- to 25-year bonds.
John Miller, chief investment officer at Nuveen Investmentsin Chicago, also sees the cheapest prices for the longer-dated bonds and predicts they will appreciate in price over time as inflationary pressures ease over the longer term, reducing the steepness in the yield curve.
Ironically, insured bonds can also be bought at added discounts now that bond insurance has fallen so far out of favor since the rating downgrades. This month, just 8% of newly issued bonds carried insurance, compared with 25% during the first half of 2008 and roughly 50% in prior years, according to Ying at JPMorgan.
LOOK AT THE SCHOOLS
The elimination of the automatic stamp of approval that bond insurance once represented means investors buying individual issues need to do much more work to assess issuers' underlying creditworthiness and grasp the risks. For lesser-known cities and towns, the profiles of local school districts, typically available on the Web, can be a great tool, says Bill Larkin, a fixed-income portfolio manager at Cabot Money Management in Salem, Mass. Checking the success rates of schools, how many students go on to college, as well as how high income levels are in the community and whether school districts have had any funding problems, can tell you a lot about how much credit risk you may be taking on.
"I don't want to [invest] in a place that has been devastated by plant closures for auto parts," he says, adding that he prefers localities with economic opportunities.
Yields are much higher on single-A and double-A muni bonds issued to finance essential services, such as toll roads and bridges, than they were in the past—around 4.5%, in some cases, as opposed to 3.5% two years ago, Larkin says.
Questions about how long the U.S. economic slowdown will last also make bonds for essential services and electric utilities a safer bet, as their revenue streams are steadier and less susceptible to economic fluctuations, says Nuveen's Miller.
LET FUNDS DO THE RESEARCH
The economic uncertainty associated with mortgage defaults and lower home values makes this an especially good time to diversify with muni bond mutual funds and exchange-traded funds, say strategists. And the additional due diligence required in the absence of trustworthy insurance guarantees also argues in favor of mutual funds, which have the staff and expertise for that kind of work.
Mutual funds are particularly advisable for investors interested in bonds rated double-B and below, since, besides good yields and diversification, they offer the liquidity that single issues, especially below investment grade, don't, says Larkin at Cabot.
Another plus for bargain-hunting investors: As rating agencies recalibrate their rating scales, one result could be a number of rating upgrades. The agencies have been under pressure to apply the same global rating standards to U.S. munis that they use for corporate, sovereign, and other types of bonds. Those changes, which have the potential to boost ratings on many muni issues, have not yet been incorporated into muni bond prices, says Miller at Nuveen.
In a July 31 draft proposal of its new rating scale, Fitch Ratings said that after the recalibration, the percentage of state and local general obligation credits in the double-A and triple-A categories is expected to rise to about 86%, from 58%. That will give hedge funds and commercial banks a much bigger basket of issues to choose from in building up their portfolios, and it will enhance overall liquidity in the market—one more reason for individuals to give munis a closer look.
Bogoslaw is a reporter for BusinessWeek's Investing channel.
