With Markets Volatile, Munis Are Worth a New Look

By Matt Webster

Tax advantages may be a difference-maker in a volatile investment climate.

In August 2011, the credit-rating agency Standard & Poor’s removed the U.S government from its list of AAA borrowers for the first time, citing diminishing confidence in the government’s ability to manage its finances in the current political environment. Yet even with the increased risks, U.S. government bond interest rates are near historic lows.

Against that backdrop, stock-market volatility has become the “new normal.” It could be European debt worries, investor emotions or an obsession with quarterly performance that leads to constant investment turnover. In any case, daily stock market gyrations of several hundred points leave investors fearful of losses and wondering what’s next.

These developments are leading investors to take a fresh look at the financial markets and ask “what investments should I be considering today?” This may be a good time to give municipal bonds a fresh look.

Tax-exempt municipal bonds enjoy an important advantage over corporate bonds: the interest paid to investors is not subject to federal income tax. And in most places (including Kansas and Missouri) if you hold a municipal bond from your home state, it, too, is free from state income taxes. Most municipal bonds are tax exempt, except a relatively small number of taxables issued for certain special purposes. For individuals, the higher your tax bracket, the greater the value of the municipal bond tax exemption.

The current lower interest rates paid to investors by state and local issuers help cities, counties, states, school districts and other issuers finance their public projects at lower borrowing costs compared to financing in the taxable markets or through conventional bank loans. Lower tax-exempt municipal bond rates mean more dollars can go directly into projects, which is a benefit to local tax payers and economies across America.

Recently, though, the popular press has highlighted a few horror stories: Harrisburg, Penn., and Jefferson County, Ala., filed for municipal bankruptcy after drawn-out efforts to restructure problem bond issues. These problem bond issues are the exceptions to what is generally a strong and stable market.

Most dramatically, last fall, banking analyst Meredith Whitney appeared on a 60 Minutes report titled “The Day of Reckoning” and forecast trouble in the $2.9 trillion municipal bond market. Her prediction was that “sizable defaults” could occur in 50 to 100 cities and towns in 2011, potentially amounting to “hundreds of billions of dollars worth of defaults.” The basis of her analysis was never very clear, but the reality has been more positive and far less dramatic and points to the underlying strength of the municipal bond market.

According to industry publication The Bond Buyer, no state or local government general obligation bonds have defaulted so far in 2011. The defaults that have occurred have been largely among more speculative non-rated bonds that are typically not sold to individual investors. Even among these speculative issues, 2011 has had a lower default rate compared to 2010.

Why have the bold predictions of massive defaults not come true? Largely because of the underlying strength of states, counties and cities across the U.S. Two great examples are Missouri and Kansas. Missouri has a Standard & Poor’s AAA rating (higher than the U.S. government’s). Kansas has a Standard & Poor’s AA+ rating (the same as the federal government).

Conservative financial management, the mandate for annual balanced bud-gets and manageable debt levels keep credit ratings strong. Most important, the strong credit ratings provide a valuable benefit—very low borrowing costs, especially when compared to financially weaker states like Illinois or California.

Given that investment-grade bonds offer historically attractive tax-equivalent yields compared to U.S. government bonds, what should investors look for?
Individual investors may want to focus on investment-grade bonds. Credit-rating agencies have become more cautious and demand accurate and timely information.

Ratings are not a guarantee, but they can be a useful way to compare risk among various bond issues.

Smaller non-rated bond issues can sometimes be good investments for sophisticated investors, but be sure the issuer and bond underwriter have done complete due diligence.

For any bond transaction, research the issuer and its financial condition. Many local municipalities have strong investment-grade ratings, including Kansas City, Jackson County, Overland Park, Platte County and local school districts. A great deal of financial information is now freely available on-line from various information services.

Most important, know your risk tolerance and your investment objectives, and consider working with an experienced financial adviser who can help you find appropriate investments.  

About the author

Matt Webster is Managing Director and investment banker at Oppenheimer & Co.