Municipal Bond Commentary
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At Oakwood, we believe a well-structured munici-pal bond portfolio should contain two basic features, dependable tax-free cash flow from coupon payments and market growth in excess of inflation. This is especially important to heavily taxed individuals who at some point may depend on tax-free cash flow to meet expenses. To reach this objective, all investments must be first and foremost safe – return of capital is more important than return on capital. As many of you are all too aware, California, like many states throughout the nation is suffering deterioration in credit quality. The rating service Fitch recently cut the state’s general obligation rating, already the lowest in the nation, to BBB. Unfortunately, lawmakers remain gridlocked on how to exactly deal with the $24 billion budget shortfall. Consequently, a difficult challenge now appears almost destined to turn into a catastrophe.

For more than two years, we have avoided all purchases of insured and non-insured State level bonds. While most market experts say it is unlikely that California will default on its debt, we still feel it imperative to steer clear of the state’s general obligations. However, even during the Great Depression, municipal investors lost less than one-half of one percent of their portfolio to defaults. In addition, we continue to maintain stringent quality standards on all holdings. This includes local municipality general obligations that are secured by dedicated property taxes, collected separately; or essential service type bonds carved out specifically for the payment of interest and principal. In most cases, to include the State, payments to bond holders are prioritized over other services by the State constitution and court rulings. States are not able to file for bankruptcy under the existing bankruptcy code. As a sovereign entity, there is no established way for states to seek court protection as other local governments can under Chapter 9. Unlike a corporation, a municipality cannot simply go out business and disappear.

Also, many municipal bonds have the ability to effect an early retirement or call of their outstanding bonds. Unfortunately, this untimely retirement of bonds can significantly alter the client’s expectation of a dependable tax-free income stream. While details outlining that potential event are always described in a municipality’s official statement, deciphering these complicated contingencies can be difficult and requires specialized expertise. With this in mind, we remain careful in our use of callable bonds. When we do, we insist on a very narrow separation between a securities shorter call date and final maturity. This provides us the necessary income stability and helps to reduce market volatility.

The second ingredient to a well-structured municipal portfolio, market growth in excess of inflation, requires at a minimum that all securities retain full value in the marketplace. This is especially important during difficult market periods. We are pleased that Oakwood portfolios continue to see positive growth, as the stock market and economy search for direction.

Municipal bonds are more popular than ever. This could be the result of an aging population that demands an increasingly conservative asset allocation. It may also be that municipal bonds have proven through the years to be among the safest of investments, without incurring the cost of significantly diminished returns.