Value in the Municipal Market
December 16, 2008
With yields offered by U S Treasuries near historic lows due to the worldwide flight to quality, municipal yields, especially for longer term issues, have trended higher since late November. The primary reason is an insufficient demand to meet heavy year end issuance, with individuals the only buyers. Mutual fund holders have been net sellers, insurance companies have been cautious, and the non-traditional buyers (e.g. Tender Option Bond programs and hedge funds) have been decimated while being forced to deleverage. Compounding this situation has been an unwillingness to commit capital on the part of broker-dealers, whose ranks have been diminished this year following the demise of Bear Stearns and Lehman Brothers.
While many states and cities are facing rising budget deficits, we believe that intermediate term municipal securities of select essential service revenue and high-grade state general obligations bonds currently offer a compelling investment opportunity for high net worth investors. These securities present their best relative value when compared to Treasuries in a generation. Currently, ten-year AAA rated municipal bonds yield approximately 150 basis points more than the ten-year Treasury note, even though municipal bonds have historically traded at lower yields than comparable maturity Treasuries due to their tax-exempt nature. Prerefunded bonds ("PreRes"), which are basically tax exempt Treasuries, have experienced tremendous demand and have been the best performing Muni sector in 2008. Other high-grade municipal bonds continue to have access to the market, but yields have risen and spreads between AAA and AA bonds have widened. Lower investment grade issuers have been shut out of the new issue market and outstanding debt in this category has been illiquid in the secondary market.
As the markets are forcing investors to pay up for risk-free investments, Treasury bills are at record low yields and certain bills currently carry interest rates of 0%. We believe short-term investors in taxable accounts should consider shifting money out of Treasury bills into high quality short-term municipal issues, including variable rate demand notes, tax-exempt commercial paper, and short-term municipal bonds. Short term municipal bonds are very attractive relative to Treasury bonds stemming from flight-to-quality considerations as well as the perceived risk of municipal bonds due to the deteriorating finances of many municipalities. We believe the prices of selected issues compensate investors for these risks. Municipal defaults for general obligation and essential purpose revenue bonds are extremely rare. While the supply of securities in these asset classes has been limited, it is still possible to uncover appropriate investments. For risk adverse investors who prefer the safety of U.S. government bonds, we recommend the purchase of short term pre-refunded municipal issues that are secured by escrow accounts comprised of full faith and credit U.S. government obligations (supply is also limited) and FDIC guaranteed depository institution bonds (maturities range through 6/30/2012).