4 Strikes Against Municipal Bonds? (Wait, aren’t there only 3 strikes per out?)

 

Ronald Delegge (of etfguide.com) recently wrote “4 Strikes Against Municipal Bonds” for Advisor One.  In the article, he makes the case against investing in municipal bonds.  I could not disagree more with the article.  

Let’s start with his 4 Basic Points:

1) The Municipal Bond Market Lacks Transparency
2) Bond Insurance Has Dried Up
3) Defaults Are Materially Higher Than Reported
4) Savvy Investors Are Bailing

Right out of the box, I want to say that each of these points has a factual basis and they sound horrible.  However, I think that Mr. Delegge overestimates the importance of each of these points with regards to its impact on investment returns.

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1) The Municipal Bond Market Lacks Transparency

For retail investors, the municipal bond market does lack transparency.  There has been disgraceful actions taken by brokers like David Lerner Associates where they mark-up prices by 5% or more to retail clients.  In general, non-institutional municipal bond trades with sizes under $50,000 have markups of 2.5% compared to larger sized trades between institutions. (You can read more about this here.)

For institutional investors, there is fairly good sense of “fair pricing” even if there may not be a published bid or ask on a particular bond.  There are two organizations (Municipal Market Data and Municipal Market Advisors) that on a daily basis construct yields curves that are used to by the market to help determine pricing.  Retail investors and their financial advisors have two ways to access institutional pricing:

  1. Indirectly through buying a fund or
  2. By taking part in a “retail offering period” where retail investors get the same exact price as institutions.

In short, the transparency issue is only a problem when buying individual bonds on the secondary market.

 

2) Bond Insurance Has Dried Up

Less than 10% of new municipal bond issues have bond insurance.  Prior to 2008, many municipal bonds carried AAA credit ratings because of insurance against default, which was provided by private companies.  Essentially, insured bond issues got to use the rating of the insurer instead of their own.  Unfortunately, the bond insurers did not deserve their credit ratings and took a beating during the financial crisis.  Since then, most municipal bond issuers and bond buyers question the additional value of bond insurance.

However, municipal bonds don’t need bond insurance. They are super-safe products. The overwhelming majority of municipal bonds are investment grade. The historical annual default rates of municipal bonds are microscopic, far lower than corporate bonds. The lack of bond insurance has not impacted the demand for municipal bonds, as the insurance was never really needed in the first place.

 

3) Defaults Are Higher Than Reported

The New York Federal Reserve issued a report recently that municipal bond defaults were under-reported by a factor of 36x.  While headline grabbing, the report actually contained no new information.  There are several problems with this report, and the biggest is how they measured defaults.  They included defaults by very, very, small unrated issues.  The municipal bond market is a $3.7 trillion dollar market, and these under reported defaults involved less than $5 billion of bonds (0.1% of bond issues by dollar amount).  If you stick to rated municipal bonds, there is no problem with under-reported defaults.

 

4) Savvy Investors Are Bailing

The savvy investor is Warren Buffett. While Buffett has been very savvy (even conniving in the case of Res Cap) about buying individual bonds, his track record on making  broad bond market calls is dreadful.  We went through his annual letters to shareholders and found Buffett to be a great contrary indicator.

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