Municipal Bond Commentary
Munis Offer Attractive Opportunities

At Oakwood, we see an opportunity for investors in the higher income brackets and for investors living in highly taxed states like California and New York.

Spreads between tax-free bond yields and taxable Treasury yields have never looked more attractive. Specifically, municipal yields have surged in recent months as the weakening economy erodes the tax base of state and local communities, and as investors avoided munis in response to perceived increased credit risk. Adding to the rise in rates was heavy selling by hedge funds and ongoing downgrades of secondary bond insurers including FGIC, AMBAC, and MBIA. Unlike Oakwood clients, individual investors and municipal bond funds were hit by the muni market’s abrupt sell-off.

Tax regs exacerbate market woes
An additional element plaguing municipals is the enormous amount of secondary market munis falling victim to de-minimus tax rules. This rule specifies a market price discount level on each muni at which future price appreciation to par is exempt from taxes. If purchased below this threshold, all subsequent growth is taxed. In anticipation of this, at Oakwood, we limited our investments to premium-priced or above-market munis with a high cash flow coupon structure. This provides us with an especially valuable cushion in the event that prices decline. In fact, while many investors have suffered significant losses from the recent erosion in longer municipal bond values, our clients are still enjoying positive returns.

Standard tools for evaluating muni attractiveness still work
In order to identify attractive maturity areas for potential investments, we use the corporate bond sector as a roadmap for valuing municipals of similar maturities.

While many areas of the curve suggest relatively good value, the graph clearly indicates the benefit of extending out to longer maturities. In response to reasonable concerns arising from recent credit quality deterioration, investors can take comfort from the fact that municipals have consistently delivered much better credit performance than corporate bonds. In fact, during the Great Depression, no state defaulted and overall defaults at local levels were very low.

Caution mixed with opportunity
Many municipalities around the nation face significant budget challenges. We understand and agree with consensus forecasts that this budget situation may indeed worsen in the months ahead. In response to this, we continue to refuse to compromise on quality and will only own the highest quality municipal bonds.

Oakwood’s experience and judgment provides us the maximum flexibility to seek out attractive investment opportunities on our own timetable. We look forward to a time when the economy stabilizes and municipal bonds return to a more normal relationship to Treasuries. When this occurs, and we expect it to occur soon, we believe municipal bonds will provide solid performance to our clients.