The first quarter of 2011 saw little activity in the municipal bond market, with $44.4 billion worth of municipal bonds issued, the lowest level since the first quarter of 2000, when $39.1 billion was issued, according to data from Thomson Reuters.
Some analysts, notably Meredith Whitney, are predicting large municipal bond defaults.
“You will see defaults,” Whitney told CNBC. “You have debt that’s just not backed by ample cash flows, ample revenue. You’ve got too many drains and demands on state revenue. I’ve never said that a state would default, but I think the local municipal bonds are at a significant risk of default.”
“Four to five years ago, municipal bonds were considered completely safe investments with positive benefits. They were just as good as cash and offered tax benefits,” says Ari Socolow, editor of bestcashcow.com, a site that advises consumers on rates for savings accounts, CDs, and “cash equivalents.”
Municipal bonds were one of those cash equivalents but no longer are, according to Socolow.
‘Significant Risk Premium’
“Now we have discovered that risk is back. Investors need to look carefully at these bonds before they consider them to have the same security as a savings account. There is a significant risk premium,” he said. “Over the next couple of years, I do not think municipal bonds are assets that will perform well.”
Others are less negative in their outlook for municipal bonds. Many municipal bond investors pulled out of the market after hearing Whitney’s bearish forecast for municipal bonds, which she delivered in March, according to Rick Ashburn, chief investment officer for Creekside Partners LLC, in Lafayette, California. Whitney’s comments tend to carry a lot of weight because she is widely recognized as the first analyst who warned of the recent banking crisis.
Thus retail investors panicked, Ashburn argues. While acknowledging concerns about some areas of the municipal bond market, he says there are many other areas where Creekside and other investors were able to purchase municipal bonds at very attractive rates.
‘Enormous Buying Opportunity’
“The news cycle has been very negative. That translates into a perception of increased risk for bondholders. But that created an enormous buying opportunity,” Ashburn said. “We tripled our holdings of municipal bonds” over three months during the spring.
The key, according to Ashburn, is to choose bonds that have almost no risk of default, namely revenue bonds that fund infrastructure projects. They are supported by the income generated by those projects, such as water bonds to support water works. Ninety percent of the bonds that have defaulted recently are general obligation bonds, with no income generation to support them. An example would be a new bond to support a housing subdivision.
Another important element, Ashburn said, is that his company plans to hold the bonds to maturity, typically five or 10 years in the future. That means even if the market stays relatively weak for a while, his firm will receive the stated interest rate when the bonds mature. Bond prices tend to rise and fall with interest rates, but that doesn’t matter if the bonds are held to maturity.
Significant Market Change
William Belanger, vice president for Morgan Stanley Smith Barney, New York, says the municipal bond market has changed significantly in the last couple of years. It used to be one monolithic market, with almost no risk of default. All municipal bonds were viewed as “good.”
Now, however, there are definite differences in the quality and risk of the bonds, with municipalities in cash-strapped states like California and Illinois having to pay higher interest rates just to pull in enough investors to fund bond issues. Municipalities in more fiscally sound states like Indiana have been able to keep municipal bond interest rates relatively low.
“What we’re looking at now is a ‘spread market,’ with some bonds paying much more than some others,” Belanger said, noting taxable bonds are performing much better than tax-free bonds.
Phil Britt ([email protected]) writes from South Holland, Illinois.