When Shopping for Municipal Securities, Credit Quality Critical
Retail investors continue to rank credit quality high at the top of their list of criteria when shopping for municipal securities, whether they be individual bonds or tax-exempt bond funds.
The concern over credit strength persists even though recent predictions of widespread municipal defaults and bankruptcies have not come to pass, according to industry analysts and portfolio managers.
Though there is currently strong demand from the retail crowd compared to early 2011 at the height of a sell-off in muni bond funds, many conservative mom-and-pop investors are still very guarded, the experts said.
“Meredith Whitney fanned the flames of those fears — way overdone — but the fears were and still are there on the retail side,” said John Mousseau, managing director and portfolio manager at Cumberland Advisors in Vineland, N.J.
“We think investors are worried about muni credit from both the risk of eroding credit quality, or from just headline risk,” he said.
Whitney, a well-known banking analyst, predicted late in 2010 that there would be “hundreds of billions” of dollars in municipal defaults.
Mousseau cited the distressed Rhode Island capital of Providence. Standard & Poor’s on Tuesday lowered its long-term and underlying rating on the city’s general obligation debt to BBB from BBB-plus and maintains a negative outlook.
The action came on the heels of downgrades in March by Fitch Ratings to BBB from A and by Moody’s Investors Service to Baa1 from A3.
“Underlying credit quality is absolutely one of the most important factors retail investors are considering,” said Tom Kozlik, director and municipal credit analyst at Janney Montgomery Scott LLC.
Mike Pietronico, chief executive officer at Miller Tabak Asset Management in New York, said the retail market is still harboring apprehension.
“No longer do investors see fixed income as having virtually no risk other than interest-rate volatility,” he said. “It is clear that capital-preservation strategies are at work as the asset class continues to see solid demand even as rates close in on generational lows.”
“Retail investors are now clearly more driven by safety, bond structure and achieving geographic diversification,” Pietronico said. “While yield will always be of importance to retail investors, the problems surrounding sovereign debt in Europe have reshaped what many believed was 'money good.’ ”
Meanwhile, the robust returns for municipal bonds during the latter part of 2011 boosted retail investors’ confidence, demonstrated the market’s strength and resiliency, and helped many shrug off some, but not all, of their fears, Mousseau said.
At the close of 2011, the 10-year triple-A bond dropped to a record low of 1.83%, municipal bond mutual funds boasted four weeks of strong inflows and the sector as a whole returned 10.7%.
“The long-term story on municipal bonds is and continues to be quite good,” Mousseau said.
Municipal bond yields last week again were setting record lows, according to Municipal Market Data.
On Wednesday the 30-year fell one basis point to 3.08%. That beat its previous record of 3.09% set Tuesday, which topped the prior record of 3.13% set Monday. Before that, the previous low was 3.14% set on Feb. 2.
Individual investors so far this year have been plowing cash back into muni bond funds.
Despite the recent strength, other factors, like the collapse of the triple-A municipal bond insurance industry, continue to weigh on retail investors’ minds, causing them to focus more attention on the importance of strong underlying credit quality, sources said.
Currently, only Assured Guaranty Ltd. is offering new insurance for municipal bonds, enhancing about 5% of new par value. That’s a far cry from the more than 50% of new issuance that was once insured in any given year by the large monoline insurers, before they lost their top-flight ratings during the financial crisis.
A fledgling municipal bond insurer, Build America Mutual Insurance Co., hopes to launch by mid-year.
“In a world without much insurance, credit surveillance is very important to retail investors and that is an aspect of bond management which is clearly ramped up in importance versus a few years ago,” Mousseau said.
Kozlik added: “I believe that most retail investors were focused on underlying credit even before the supply of bond insurance dropped and the financial crisis of 2008. But recent events have also drawn more attention to the sector, such as Meredith Whitney’s strikeout at the end of 2010 and into 2011, and various other predictions calling for the collapse of the municipal market.”
To help allay their clients’ fears and satisfy their demand for high quality, muni experts recommend a wide range of investment options in the current market, from GOs to essential-service revenue bonds.
“We are fans of the A-rated general obligation sector right now, as it represents true discounted value as opposed to triple-A rated debt,” Pietronico said.
On Thursday, for instance, A-rated GOs due in 2042 yielded 3.81%, according to MMD. Generic, triple-A GOs due in 30 years yielded 3.09%.
“One should be suspicious of such high ratings in this challenging economic environment,” Pietronico said. “Triple-A-rated bonds introduce higher durations into portfolios with interest rates at generational lows. This, combined with the likelihood that triple-A ratings may be hard to justify given the federal deficit and state pension obligations, gives us the view that the best risk-reward investment falls in the A-rated range.”
Meanwhile, Mousseau sees value elsewhere.
“I think the appearance of a dedicated revenue stream with essential service revenue bonds or sales tax-backed bonds has a much better appeal to clients than the old primacy of general obligation bonds,” Mousseau said. “I think most investors realize that though pretty solid, from a general obligation standpoint if there are severe problems, an investor is really just an unsecured creditor.”
He referenced the Port Authority of New York and New Jersey’s debt as an example of the type that has strong retail appeal chiefly because it is backed from a variety of revenue sources. “You can fly out of, or drive over or through, the sources of revenue paying your bonds,” he said.
On Thursday, a $1.4 million block of the port’s consolidated bonds with a 4 1/2% coupon due in 2034 traded six times with yields ranging from 3.24% to 4.09%, according to investinginbonds.com, the Securities Industry and Financial Market Association’s website. The bonds have underlying ratings of Aa2 from Moody’s, and AA-minus from Standard & Poor’s and Fitch.
Kozlik, on the other hand, is recommending a mixed bag of investments for Janney’s retail clients, even those with the need for slightly more yield.
“We recommend more conservative investors consider high-quality general obligation and revenue bonds,” he said. “Those looking for additional yield are reaching further down the credit curve, but we advise investors to make sure they have a complete understanding of an issue’s underlying credit quality before they do so.”
Overall, despite their skittishness regarding credit quality in the municipal market, retail investors, especially baby boomers, refuse to take a backseat in a market that plays a crucial role in their portfolios and asset allocation, experts said.
“Retail investors are important and definitely participating at a strong pace — sometimes driving bond sales,” Kozlik said.