Muni Markets: Maneuvering Through the Minefield Webinar Notes


By Tedra DeSue

(August 22nd, 2012) Contrary to the growing belief about the dwindling safety of municipal bonds, there are market players who would beg to differ and they point to several factors to back up their positions.

Some of these believers on yesterday participated in a webcast sponsored by Investment News. The topic – “Muni Markets: Maneuvering through the minefield,” was timely considering several developments over the past few weeks that have raised anxiety over investing in municipal bonds.

The most recent development resulted from a quarterly regulatory filing by Berkshire Hathaway in which it revealed it had terminated credit-default swaps that insure $8.25 billion of municipal debt. Pundits immediately summed up this move as the company, chaired by the legendary Warren Buffet, wanting out of municipal bonds because of the increasing risk that more issuers will default on their bonds. (read our take in “Buffett Muni Story: The Mainstream Media Gets it Wrong Again“)

However, panelists participating in yesterday’s panel didn’t’ see the termination this way. They agreed that Berkshire Hathaway’s action didn’t signal that Buffet has serious concerns about the municipal bond market.

The panelists also took issue with a controversial study by the Federal Reserve Bank of New York that was released last week. The report also put municipal bonds in a negative light, and was enough to make investors looking for guidance from rating agencies cringe.  (read our take in “Bond Experts Slam NY Fed Report“)

The report stated that municipal bond defaults are more common than reported by rating agencies, which panelist Stephen Winterstein disagreed. He is a managing director and chief strategist of municipal fixed income at Wilmington Trust.

“Moody’s Investors Service and Standard & Poor’s rate more than 90% of the [municipal] bond market,” he said.

Investors may take comfort in the fact that the doom and gloom predictions about the fate of the municipal bond market have not, and will likely not, come to fruition. However, there is no escaping the fact that the makeup of municipal bond portfolios has changed, Winterstein said.

This partly stems from the toll the financial collapse took on monoline insurers, like MBIA and Ambac Assurance Corp., which insure municipal bonds. These insurers were long considered necessary for credits whose underlying rating was not triple-A. However, these insurers stepped away from insuring the typical municipal bond deals, and delved into riskier areas such as structured finance and credit default swaps, Winterstein said. When these kinds of investments began to go south in 2007, so did the financial soundness of these insurers.

“The credit quality of [municipal bonds] is being challenged,” Dalpaiz said. “[The market] went from being a homogenous market to being a stratified and fragmented market.”

Still the demand for municipal bond paper remains strong. According to Lipper, a unit of Thomson Reuters, U.S. municipal bond funds for the week ended Aug. 15 had net inflows of $964 million, which was down from the $1.14 billion reported in the previous week. Still, the four-week moving average remained positive at $854 million, according to Lipper.

Bernardi Securities president Ronald Bernardi, another panelist to speak during the webinar, said the fact that there is fragmentation creates “wonderful” investment opportunities.

“In 2008 and 2009, we were nervous buyers and investors, but it turned out to be some of our best investing,” Bernardi said.

Investors should take solace in knowing that it is in the best interest of municipalities to do all things possible to avoid defaulting on their bonds and or filing for bankruptcy, Dalpaiz said.

“There are tools they can use to self-correct,” Dalpaiz said. “They can raise taxes, cut expenses, sell government assets, use their rainy day funds and refinance their debt.”

The individual investors’ portfolios have changed. The mantra, traditionally, was to make sure you had ‘triple-A rated, insured paper in your portfolio. However that has gone away.

“Investors are left with portfolios that look nothing like they did four years ago,” Winterstein said. “What we have today are portfolios that are stratified.”

The most noticeable change in municipal bond portfolios is the credit quality of the bonds in them. They are increasingly being made up of debt from issuers that have bond ratings that are not triple-A due to municipal bond insurance. Instead, portfolios are being created that have more bonds from issuers with underlying ratings in the single-A or even single-B ratings.

This creates the need for even more due diligence on the part of bond buyers. This has to come in the form of a bottom-up credit analysis, agreed the panelists. Investors are leaning more on their financial advisors to help them find the land mines and avoid them when it comes to risky bond issuers.

Dalpaiz pointed out that rating agencies are taking a hard stance against municipalities that threaten that bankruptcy is their only alternative.

“[Rating agencies] don’t want issuers to use it as a tactic or a negotiating ploy,” Dalpaiz said. “Municipal market participants should applaud this.”

While there have been issuers that have failed to pay the principal, interest or both on their bonds, i.e. Jefferson County, Ala. and most recently Stockton, Calif., these failures are rare. The vast majority of issuers do pay off their bonds because the price for failing to do so is so high.

They want to avoid bankruptcy because they know that they need access to the bond market to fund most of their capital projects, Dalpaiz noted.

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