Municipal Bond Commentary
Municipalities Overdue for a Raise

Moody’s Investors Service will soon implement a global rating system, replacing the current system that differentiates between corporate, state, and local government issuers. This means that more than 70,000 state and local municipal bond issuers will now be rated on a scale comparable to corporate bonds. Market participants have pointed out that the old rating system treated state and local government issuers unfairly, in terms of default rates relative to similarly rated corporations, even though municipal bonds have structural advantages.

We agree with this opinion. In fact, a recent Moody’s default study shows an extraordinarily low 0.09% municipal default rate over the past 39 years. Out of 51 total defaults, only 3 were general obligations, which as you may know are supported by the municipality’s unlimited taxing ability. In addition, state and local governments amortize debt service payments over the life of the outstanding bond, which is not the case in the corporate arena. This further increases the probability that the money to pay off the bond at maturity will be available. As a result, a comparable-rated municipal bond can actually be of higher quality than a corporate bond. The recalibration to a global scale will benefit municipalities that depend on a favorable rating to reduce borrowing costs. This especially benefits issuers of weaker quality and should increase the market value on existing securities.

The change may result in a broadening of our investment choices as our universe of investment considerations expands. However, even though yield differentials between A and AA rated bonds are at twice-historic wide levels, investor anxiety and an uncertain economic outlook may continue to drive quality perceptions. We are reminded that for years, both the private and public sectors have levered up spending and debt obligations. Most are still in the early stages of scaling back.

One clear fact is that investors are fleeing low or no-yielding money market mutual funds in search of higher yields. This phenomenon is bolstered by expectations of higher marginal tax rates and the scarce supply of investable bonds. We also note that currently more than 30% of newly issued municipal bonds are of a taxable variety, issued under the government-subsidized “Build America Bonds” program.

As set forth in the last Oakwood Outlook, we find value in intermediate maturity 5-to-7 year callable bonds. This strategy can add yield and reduce tendencies to over-extend into longer maturity areas. Remember that “chasing yield” by making concessions in quality and maturity often leads to excessive market exposure and the potential for loss.

To sum up, we are very pleased by Moody’s decision to re-evaluate its credit ratings. Investors have confidence in a municipality’s ability to make bond payments. California and Nevada, among other states, are still struggling under the weight of housing foreclosures, high unemployment, and a reluctance to reduce headcount and budget deficits. The problem unfortunately does not stop there. Many municipalities throughout the country are relying on one-time solutions to deal with long-term problems. We meet this challenge with stepped-up research and with selection of high quality issuers. This places us in an enviable position when making tactical decisions, on our timetable, as we go forward.