Municipal Bond Commentary
Dodging Minefields

The municipal market faces challenges on a daily basis. Wealthy investors nonetheless continue to embrace the asset class, as 67% of the $2.8 trillion in outstanding bonds are held by individuals with financial companies a distant second. (see chart) Despite this commitment, muni investors face minefields. One obstacle is anemic and deteriorating tax collections by state and local governments. Look no further than California to see how a weak economy combined with poor fiscal management leads to budget shortfalls and financial chaos. The governor signed a budget last year that included some cuts, raids on local funds and accounting maneuvers, in an effort to close the state’s $24 billion budget gap. Since then California has projected an additional $6 billion gap. With unemployment now at 12.4%, we only hope the worst will be over soon. One certainty is that this environment warrants frequent review of portfolio holdings’ credit quality to confirm financial objectives and maintain reasonable risk profiles.

One major emerging concern confronting municipalities involves pension and other long-term commitments made to retirees. States including Illinois, Colorado and Minnesota have under current consideration benefit cut-backs including cost of living freezes. In fact, Illinois faces a $13 billion budget shortfall, equivalent to fully half its total yearly budget. Unfortunately, many of these benefit modification proposals are likely to be challenged in court.

Issuer’s day of reckoning approaches

So have tax exempt issuers finally awakened to the need for structural adjustments well beyond incidental cuts or accounting maneuvers in order to balance budgets? Not really. On balance, they still continue to address shortfalls through the issuance of more debt. Reining in the gap between revenue collections and spending involves political conflict, so many continue to rely on one-off solutions to long-term problems. Since nationwide employment peaked at 115 million in 2007, businesses have cut approximately 8.5 million jobs, a 7.4% reduction. By contrast, local governments continued adding employees through 2008 and have since fired only 140,000, or less than 1 percent. Provisions within public employee contracts or other labor agreements may well hamper the ability to cut back further.

Chapter 9 bankruptcy for municipalities is available, but rare. States cannot renege on obligations simply by declaring default, although many threaten to do so. Still ratings downgrades can affect the value of a bond and impair its liquidity in the marketplace. This can devastate a client seeking liquidity to meet cash needs, in contrast to a professional manager, like Oakwood, who endeavors to take advantage of market opportunities or portfolio restructuring.

Through our extensive security selection process and insistence on holding only the highest quality securities, we are pleased to report positive performance through mid-year. Furthermore, all holdings are liquid and are readily available to meet client needs, if necessary, or to implement changes in strategy.

We see recent evidence that the tax-exempt municipal sector is lagging taxable bonds, which is clearly reflective of municipalities’ financial woes. To capitalize on this, we continue to swap our low-yielding short maturity positions, in favor of 5- to 10-year bonds. This allows for yield improvements well beyond Treasuries and on a tax-adjusted basis, represents approximately one percent more yield than comparably rated high quality corporate bonds. This relationship is shown in the following graph marked yield comparisons.

California’s elevated yields

Despite the concern, we are finding good value in select communities throughout California. As you know, California is large, diverse, and includes numerous well-managed and/or wealthy communities, while the State is among the lowest rated and worst run. The state-wide bias stigma drags down the securities of more desirable local communities. This provides an opportunity for both in-state and out-of-state clients, to capture historically high relative yield. In the past, California yields were below lower taxed states, not higher. To further reduce the potential for risk, we continue to focus our attention on dedicated sales tax revenue bonds, essential service type providers or select general obligations rated AA or higher.

Investors need to be aware of the difficulties facing issuers of municipal bonds. The power of timely market information and state-of-the-art systems combined with extensive experience are essential tools to making and monitoring investment decisions. This gives Oakwood an advantage that our clients enjoy. For the balance of the year, we expect investors to increase their allocation to municipal bonds. As the stock market struggles for direction and international problems mount, munis are a safer option for investors seeking shelter from taxes. At some point, an improved economy will inevitably push interest rates higher and favor higher stock positions. We’ll keep you posted as a clearer picture emerges.