Amid talk of Federal Reserve tapering, Detroit’s July bankruptcy filing and concern about whether Puerto Rico can repay all of its $70 billion municipal bond burden, munis have been in a swoon that has created a buying opportunity. Muni bonds have rebounded from their September lows. The Barclays municipal bond index yields 3.1 percent, up from 2.17 percent at the end of 2012.
“There are munis that are attractively priced,” says Guy Davidson, director of municipal investments at AllianceBernstein in New York, which manages $30 billion in muni bonds. “The reason why is that they are in two scary areas — either lower credit quality or longer maturity.”
A 30-year triple-A muni now yields 4.12 percent, surpassing the 3.84 percent rate for Treasury bonds, even before accounting for munis’ tax advantage. “Usually 30-year munis yield 90 to 95 percent of Treasuries,” says Lyle Fitterer, managing director for tax-exempt investments at Wells Capital Management in San Francisco. “Because munis have underperformed, they look more attractive than Treasuries.” For someone in the highest tax bracket, the 30-year muni has a taxable equivalent yield of 7.28 percent.
Concern about municipal finances, while real, has been overblown, according to muni fund managers. “Municipal finances are improving,” says Issac Kuo, a municipal bond portfolio manager at Eaton Vance in New York, which manages $25 billion in munis. “You have one-offs like Detroit and Puerto Rico. But across the majority of the municipal space, we think things are improving. Revenues are higher, balance sheets are getting better, and the economy seems to be getting better.”
State tax collections have increased for 13 straight quarters through the first quarter of 2013, according to the latest data from the Nelson A. Rockefeller Institute of Government. Despite the market’s hue and cry this year, the muni default rate is less than 0.25 percent, AllianceBernstein’s Davidson says. “Most states and cities are in pretty good shape,” Kuo says. Using data from 2012 and 2013, his firm calculates that the states’ debt and unfunded pension liabilities together total a median 7.6 percent of their gross domestic product — a very manageable level.
One of the biggest challenges for investors is differentiating among bonds. “In corporate bonds, people understand that when General Motors or American Airlines goes bankrupt, it does not mean Procter & Gamble and Johnson & Johnson will experience a similar fate,” says James Evans, director of tax-advantaged bond strategies at Eaton Vance. “But in munis, many investors lump all issuers together and think everything will default.”
Wells Capital, which manages about $33 billion in munis, owns Illinois bonds. “We don’t see Chicago becoming the next Detroit,” says Fitterer. “You look at the economy and population — it’s a completely different story than Detroit. We think Illinois is one of the most attractive opportunities out there.”
A 30-year Illinois general obligation (GO) bond rated single-A-minus trades at 5.75 percent, which is a spread of 165 basis points over triple-A munis. Adjusted for taxes, the yield is 10.16 percent. On December 10, citing the state’s pension overhaul in its decision, Standard & Poor’s revised its ratings outlook on Illinois GO bonds from “negative” to “developing,” keeping its A– rating.
“Their GOs are secured; the state economy is growing,” Wells Capital’s Fitterer says. “And as the economy grows, the revenue grows. We think they have an ability to finance their debt.” Eaton Vance owns 20-year, triple-A Michigan clean water bonds that yield 4.1 percent, or 7.24 percent on a taxable equivalent basis. “Anyone would call that attractive,” Kuo says. “Because of Detroit, people are throwing the baby out with the bath water.”
Until the Detroit bankruptcy filing, GO bonds were generally seen as safer than revenue bonds, because they are backed by the full taxing authority of the state or municipality. But Detroit has fallen behind on repayment of some of its GO bonds. So now many muni investors feel more secure in revenue bonds, which are repaid with the revenue from a particular project, like a power plant. “Revenue bonds might not be subject to the political issues of GOs,” Fitterer says. “You can get your arms around revenue bonds. If GOs say pension payments come before you, that’s a concern.”
Wells is overweight revenue bonds when compared with GOs, Fitterer says. But that’s not because of any fear of GOs, he explains. It simply reflects relative value.
When it comes to state bonds versus city bonds, Eaton Vance prefers states, because they have more “scale,” including a greater ability to tax, Kuo says. “At the same time, there are fantastic local credits,” he adds. “If you have the ability to do the credit research, you can find cities you’re as comfortable with, or even more so, than with states.”
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