A few thoughts from Lebenthal Asset Management about current market conditions.
by Gregory W. Serbe
In our last update to investors, we discussed how change was a natural phenomenon, and how we must adapt to it. We are still in a period of tremendous economic turmoil and upheaval. It is still our opinion that with uncertainty comes possible opportunity. This opportunity may be in returning to the basic fundamentals of investing in the municipal bond market. More specifically, understand the risk you incur and be rewarded appropriately when you take it. The days of generic investing in “munis” are gone.
We are going to look at some of the profound changes in the market over the last two years. The 2.6 trillion dollar municipal bond market has outgrown its quiet roots and stretched far beyond being an unknown investment reserved for the very wealthy or the very sophisticated investor.
Over the last two years, the slowdown in the housing market was fueled by the collapse of subprime mortgages and other lesser quality housing loans. These loans had been dependent upon low cost financing and an ever increasing value of housing prices. As these loans dissolved into foreclosures, municipal bond investors discovered that the very insurers of the safety of their municipal bonds had been significant participants in this unrelated mortgage market. One bond insurer after another lost capital and eventually the rating services dropped their coveted “Aaa” or “AAA” rating. Concurrently, the same Wall Street investment firms that created the packaged mortgage products badly needed to raise fresh capital. The result was that by March of 2008, a major Wall Street firm was forced into a sale of itself, with taxpayers probably absorbing the losses from the transaction. Subsequently, the list of firms either closing, being sold, or drastically changing their business mix, such as abandoning the municipal market, includes some of the most well known banks and brokerages, many with antecedents that stretch back over a century.
The next element in this mix was the fact that these very firms sold derivative municipal securities and were suddenly faced with having to provide liquidity on these long instruments with short “put” or rollover maturities. As the bond insurers, whose capital standing provided the support for these bonds, lost their credit standing, many of these instruments became illiquid. New investors could not be found to purchase the issues that the old holders wanted to redeem. Dealers didn’t have the capital to take back the unwanted securities into inventory, and investors who were planning to be temporary holders found that they were frozen with their holdings. While some of these issues have been converted into long term fixed rate issues, the process has been painfully long, and slow. Additionally, those investors who owned Auction Preferred Shares of closed end bond funds faced a similar dilemma. At the end of the day, the municipal bond market turmoil became a source of commentary for the financial news media. The rating services received substantial criticism for their inability to assess the risk of the mortgage securities, and then for their poor evaluations of the risks to the municipal bond insurance companies that had insured them. Even those investors who invested in municipal hedge funds discovered that there was no safe harbor for the sophisticated investor. With the “flight to quality” of the security of U.S. Treasury Bonds, and the selling pressures on the rest of the bond market, segments within the overall bond market decoupled. Instead of mitigating the risks of investing in one asset class (municipal bonds) by shorting a different but closely related asset class (Treasury securities), the hedging of a long municipal position by a short Treasury position compounded the effects of the municipal sell-off and the Treasury rally. All of this was subject to the harsh light of daily updates in the financial media.
Additionally, the demand side of the equation shifted. Two types of significant investor classes almost completely disappeared. Municipal hedge funds have either pulled back in capital or are no longer functioning. Property and casualty insurance companies, faced with mounting losses, no longer needed the benefit of tax exempt interest and became sellers of their municipal bond portfolio holdings.
In addition to the reduction in demand due to a change in the players, the very quality of the instruments has come under attack. As reported by the Wall Street Journal on January 26, 2009, over the last decade, state and local government outlays have doubled. Now they are facing record shortfalls in tax receipts. Declining property values and homes in foreclosure will lessen ad valorem property tax collections. Lower retail sales lessen sales tax collections. Lower incomes mean less income tax collections. At the same time as cash receipts are down, the need for transfer payments has increased. Unemployment claims and Medicaid claims are up substantially. With the Federal government supporting the financial and automotive industries, naturally state and local governments have requested Washington dollars from the new administration. The best way to state their case is through a groundswell of support generated through the press. Dire predictions of grim future events help create the need for assistance.
Where does that leave the investor? It is our opinion that the market will return to the basics of investing, and that this will provide some unique opportunities. Given all the negatives (loss of bond insurers, loss of “players” in the market on both the underwriting and investing sides, and weakness in municipal budgets to summarize a few points,) there are certainly reasons to be cautious. Those same negatives are also the seeds for future opportunities. Investors no longer can view their portfolio as just “AAA insured.” The actual credit quality of the issuer becomes significant. With the decoupling of the Treasury and municipal bond markets, municipal yields are actually higher than Treasury yields, without considering the tax advantage provided by municipals. For years a long term municipal bond typically yielded between 80% and 90% of what the comparable Treasury bond yielded. Now as this is being written, the best quality municipals offer 150% of the yield of the comparable thirty year maturity Treasury, and other investment grade municipals have yields that are over 2.5% more than their comparable long maturity Treasury Bond. In our opinion, as a result of the concerns about safety and liquidity, spreads between best quality bonds and other investment grade bonds (AA or A rated) have widened out.
We also feel that the maximum tax rate will increase. It is just not clear whether the current tax laws will simply expire in 2010, or be more aggressively increased beforehand. There is a reasonable probability that state taxes will increase as well. Municipal bonds could outperform in that scenario. We also feel that as the market ceases to be dominated by a few underwriters selling generic “insured” municipals, investors will be given an opportunity to purchase bonds where credit and risk are more closely aligned. This should provide for more opportunities to capitalize on market inefficiencies and thus give a greater return from their municipal investments. And that, in our opinion, is why an investor buys municipal bonds.
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