Municipal Bond Commentary
Time for Investment Discipline

Oakwood clients enjoyed several benefits from their municipal investments in the first quarter. Perhaps the most important was capital preservation, especially when compared to equity and real estate investments. In fact, the capital preservation feature of the municipal bond sector provides an excellent complement to other investment sectors.

As the economy continues to contract, it is prudent for us to review our individual municipal bond holdings to ensure that each one remains credit worthy. Just as the lack of regulation and disclosure requirements has become a major concern for corporations, financial transparency in the municipal bond sector has also come under scrutiny.

Guard against credit shocks

At Oakwood, our most important protection against credit shocks is possibly one of the most obvious: research, discipline, technology and the collective experience in our fixed income department. This level of experience is important as the economy vacillates between contraction and expansion, and as history reveals price patterns in a particular municipality’s ability to manage through economic changes. Over the years we have seen professional managers reward consistently well-managed municipalities by placing a higher value on their bonds. To identify these municipalities, you need to have been in the market over time — as we have.

Another safeguard concerns a municipality’s value to the community as a whole. One criterion is “too big to fail.” Metropolitan areas and states fall into this category. Some clients may remember New York City’s default in the 1980s and the ensuing government bailout. Similar to disaster relief, even smaller municipalities will be rescued by their resident state, or by the Federal government, if required. For added protection, we review each bond indenture to validate the source of bond payments and to assure they are direct and irrevocable obligations with discretionary taxing power. In the case of revenue-type bonds, we are careful to select issuers whose service is considered essential and vital, regardless of economic condition.

Even the mighty can fall

This is not to suggest that a municipal bond cannot go into default. In fact, over the past year, we’ve seen a significant rise in defaults, albeit still at a fraction of total outstanding municipal debt. Hospital, housing and redevelopment projects are the most vulnerable to weakening economic conditions. In the case of default, financial support is usually determined by an entity’s value to the community. In any case, we continue to avoid these issuers.

At Oakwood, we have taken additional steps to reduce the risk of default or disruption in scheduled coupon payments. As we’ve been reporting for the last two years, we have raised our minimum quality standard on new municipal purchases to AA, absent any consideration for secondary insurance coverage. This provides us with an early-detection buffer in the event that credit conditions change.

We’re confident that with this continued discipline and our unbiased decision-making process, we are able to make sound investment decisions, even as transparency issues come under SEC scrutiny. At Oakwood, we pride ourselves in holding only the safest investments with features that are well understood in advance of purchase and that are reviewed on an ongoing basis.