By LIZ PEEK - November 27, 2007
What are the odds that a Democrat will be moving into the White House a year from now? English betting agent Ladbrokes puts Senator Clinton at a 2:1 favorite; no other candidate comes close.
What are the odds that Mrs. Clinton or any other Democrat will raise taxes? Almost 100%.
Isn't this a good time to look at municipal bonds? It would seem so, especially since these tax-exempt issues are comparatively attractive. While top-tier triple A-rated munis normally offer yields of about 85% to 90% of the 30-year Treasury bond, such securities today are yielding more than 100% of that standard. The flight to quality has been concentrated in Treasury bonds, driving up prices and creating relative value in munis.
At the same time, according to a senior vice president with Oppenheimer Funds, Dan Loughran, some municipal bonds that carry a so-called insurance wrap — meaning they are protected against default by one of the security insurance outfits — are yielding more than similar issues with no wrap. How can that possibly be?
Like so many aspects of the spreading subprime mortgage catastrophe, its impact on the normally sleepy municipal bond market is somewhat irrational. Mr. Loughran, who runs a number of Oppenheimer's municipal bond funds, says: "Credit conditions in the muni market are still very strong. But, when fear pops up in other markets, it seeps into munis."
Still, it seems downright silly that certain insured bonds are selling at a discount to similar uninsured securities. Duncan Smith, head trader for Alexandra and James Company, the latest incarnation of muni specialist Lebenthal & Co., agrees. He says insured long-term health care facility bonds have been selling lately with a 50- to 65-basis-point yield premium over uninsured similar issues. Go figure.
The problem is that companies such as AMBAC and MBIA that insure high-quality munis also provide insurance for riskier securities, including problematic CDOs. These companies provide lenders with insurance against principal or interest defaults. By acquiring such a policy, the issuer reduces its cost of borrowing, because the financial status of the insurer, as opposed to the issuer, determines the credit rating of the security in question.
Unfortunately, if the insurers themselves come under pressure, as has happened in the past couple of months, the ratings of all the securities are in jeopardy. In mid-October, the insurers began to report third-quarter losses stemming from write-downs of credit derivatives products. Since then, the shares of AMBAC, the company that first provided such coverage in 1971, are down 66%; yesterday, the stock sold at $24. Similarly, MBIA was trading at $66 on October 8; yesterday, it closed at $33.
Notwithstanding the problems faced by bond insurers, there can be no penalty attached to having the backing of these companies. Thus, to have issues selling at a discount presents managers such as Mr. Loughran with an opportunity. As investors get a little clearer picture of the extent of the potential write-downs, these insured bonds will likely recover some lost ground. Just recently, bond insurer CIFG announced it would receive a capital infusion from its French parent, perhaps providing a model for others in the industry.
So far this year, municipal bond funds have not been big winners. According to Lipper, the average general municipal debt fund has returned less than 1% to investors through October 31. Over the past three years, such funds have earned 3.06% annually. Shorter-term funds have fared better than those with longer average maturities.
Going forward, however, the prospect of rising taxes should plump up municipal bond demand. For tax-laden high-income New Yorkers, the benefits are pretty obvious. Specifically, for a New York City resident with a 41.5% current marginal tax rate, a 4% return on a local New York City agency issue is equivalent to earning 6.8% on a taxable corporate bond. A return of 4.5% equals taxable income of 7.7%.
Those equivalents rise if taxes move higher. As Mr. Loughran says: "Even if the Republicans hang onto the White House, the Democrats will have a majority in the Congress, and will almost certainly allow the Bush tax cuts to expire in 2010." One of the cuts was to the marginal tax rate, to 35% from 38%. The reversion to the higher rate alone increases the attractiveness of munis.
Another tax cut that may well disappear in 2010 is the lowered rate on dividends. When the top tax rate on dividend income was reduced to 15%, some income-oriented investors took money out of munis and invested in stocks with above-average yields that also offered the prospect of capital gains. The opposite should occur if dividend income tax rates increase. One concern shared by all investing in the muni market has been the risk posed by a lawsuit challenging state income tax exemptions in Kentucky. Although considered a long shot, the case raised some anxieties about the permanence of the industry's tax status. The Supreme Court heard arguments in the case earlier this month, and appeared to lean toward allowing the exemptions to continue.
Mr. Smith would recommend staying in medium- or short-term securities, such as those held by Mr. Loughran's Limited Term New York Municipal Fund. He says he expects the market to gain ground as the election approaches and there is more talk of raising tax rates. "The discussion alone will create demand," he said. As for munis selling at yield premiums over treasuries, Mr. Smith says it's a buying opportunity. It's happened before, he says, during past credit crises.
"This is the worst credit crisis I've ever seen, and I've been in the business 25 years." Makes municipal bonds sound even better.
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