Municipal Bond Commentary
Munis March On

Once again this year, municipal bonds are rewarding investors with solid performance, on both an absolute and inflation-adjusted basis. In fact, demand for tax-free bonds is easily outstripping the market’s available supply. For some investors, this may be hard to reconcile given the sharp drop in tax receipts to municipalities that led to an overall decline in bond credit quality. But clearly, investors still see municipal bonds as a safe haven during weak economic periods.

In prior Oakwood Outlooks, we concurred with consensus forecasts that the revenue situation could indeed worsen. We felt, however, that investors would take comfort from the fact that municipals have an extremely low default rate and have consistently delivered much better credit protection than corporate bonds. In this view, we have been proven correct.

Leaning toward longer durations

Looking ahead, the demand for tax-free bonds should continue to grow as municipalities operate more efficiently and take action to adjust their budgets. There is growing evidence that the economy has bottomed and that prospects for future growth are near. Also, there appear to be few signs, for now, that inflation will force yield levels higher. Collectively, these factors should provide market stability, and give municipal bonds a competitive advantage over investment-grade corporate bonds on a tax-adjusted basis.

Because of the natural competitive correlation of tax-free bonds to taxable bonds, we use comparative Treasury and corporate bond yield levels as part of our security selection process. The chart illustrates the present relationship between these alternative asset classes.

We view the short maturity area as unattractive. Municipals on a tax-equivalent basis are well below similar quality corporates and yield barely 1% on an unadjusted basis. However, we see good value in the longer maturity areas. The sharp steepness in the maturity curve, combined with a substantial compression in corporate bond yield spreads, works to the benefit of this longer maturity area. For example, a 15-year municipal at a yield of 3.50%, equates to a taxable equivalent near 5.40% for investors in the highest tax bracket. This represents a clear yield advantage over high quality corporate bonds. Investors could capture even more yield, if they chose to relax credit standards in favor of lower quality investments.

Budget discipline and historical low default rates alone will not cause us to drop our current high-quality preference. We need to see concrete employment gains as evidence of a clear directional change in the economy before we expand the breadth of our bond selection.

California realities

Although we expect states to successfully close recurring budget gaps, we continue to avoid California bonds on a state-level basis. We are focusing instead on essential service-type bonds and local municipality general obligations, which are secured by a predictable revenue source or dedicated property tax. The expectation is that an improved economy will be followed by growing tax receipts, and that housing prices will stabilize and again move higher. This will prompt consumer spending, a critical revenue source to states.

The current market environment presents an interesting set of opportunities. We may soon begin to swap our heavy weighting in pre-refunded bonds over to insurance-backed bonds for added yield. We believe the almost endless battering of secondary insurance carriers that led to numerous downgrades will soon be resolved. This means that some carriers like AMBAC and FGIC will no longer exist, while others like Assured Guaranty and Buffett’s Berkshire Hathaway Assurance Corporation will dominate. As new deals emerge from the strongest surviving carriers, investment choices will broaden and lead us to a swap from highest quality non-insured holdings, providing attractive yield gains.

As the economy begins to grow, municipalities will restart infrastructure projects, leading to new investment opportunities. And finally, as we approach 2010, discussions will emerge over a return to higher tax rates. This also works to the benefit of those who invest in tax-free bonds.