Tax Exempt Fixed Income Strategy
Munis Prevail Through Taxing Times

Tax-free investors face many challenges this year. Among them, the market price of municipal securities has been forced to adjust lower, due in part to changes in the landscape of secondary bond insurance.

Insurer’s vital role in debt issuance
Approximately half of last year’s new issues benefited from some form of insurance enhancement. Insurance lowers the overall cost of borrowing money for municipalities, for example, a ‘single A’ rated, 10-year-maturity bond can enjoy a monetary savings equal to approximately 20 basis points versus a similar non-insured bond. In California, the yield differential can be more than 30 basis points. The net savings of thousands of dollars easily justifies the cost of insurance. Insurance also enhances liquidity and provides comfort to investors from around the country that are unfamiliar with local-level municipal issuers.

Credit downgrades amidst new players
Unfortunately, most major insurance carriers have seen their AAA quality rating crumble, as both Standard and Poor’s and Moody’s have revalued huge ongoing losses in housing derivatives and other structured investments. With the recent downgrade in AMBAC and MBIA, five of seven financial guarantors have suffered cuts to their credit ratings. The two remaining AAA rated bond insurers FSA and Assurance Guaranty are devouring the market, along with new players, including Warren Buffett and Macquarie Corp. Below is a listing of the major insurance carriers along with their most recent debt ratings.

Wary of state-level debt
Our decision to own only high-quality investments in our portfolios irrespective of insurance has been a good one. More than any other state, California is reeling from the worst housing market in years and a significant economic slowdown. As a result, we’re avoiding state-level California bonds unless collateralized by government securities. California, the biggest borrower in the $2.7 trillion municipal market, bears the brunt of poor fiscal management and is looking at an estimated budget shortfall of over $15 billion. Adding to the problem: lawmakers are deadlocked over whether to raise taxes or cut spending.

Go local
We do see good value in “local-level” California bonds. There are many very well-managed high-quality issuers offering yields equal to states that impose little or no state tax on residents. Of particular interest are essential-service bonds for water, sewerage, transportation, as well as numerous local municipalities that have reached a proper balance between tax receipts and expenditures. The use of local-level California munis, even for non-California clients, should provide a performance benefit as the year progresses.

Muni bond outlook
After only short-lived improvement, the yield-ratio of municipal bonds to Treasury securities has climbed back to 100%. This means that you can get the same cash flow from a tax-free municipal bond as you can with a taxable US Treasury. This prompts us to reevaluate our shorter holdings for possible extension. We find a 14-year muni bond yielding 4.35% to be attractive. It equates to a 6.7% taxable yield equivalent for investors in the maximum tax bracket. To compare, 14-year Treasuries are presently yielding 4.45%, while high-quality corporate bonds yield between 5.5 to 5.75%.

As the November election approaches, it’s unlikely that tax brackets will move lower; in time, they could even move higher. This means the demand for tax-free bonds should remain strong. We’re confident that the problems facing insurance carriers will soon be resolved, and that municipalities with sound budgets will be met with strong investor demand. We continue to emphasize stringent quality standards and avoid all temptation to “chase yield” at the expense of liquidity and the potential for future market appreciation. We’re likely to see a pick-up in municipal defaults this year, so every alternative must be examined carefully prior to investment. That’s why we’re here.