(May 2012) On May 2nd, Learn Bonds interviewed BlackRock’s Peter Hayes. BlackRock oversees more than $106 Billion in municipal bond investments, and as the chair of their Municipal Bond Market Committee, Peter is one of the most influential figures in the market today. Our goal for the interview was to get Peter to outline the process Blackrock goes through when buying individual municipal bonds, and he delivered.
Here are the top 5 tips that came out of the interview for Municipal Bond investors.
Tip 1: The Municipal Bond Market Calendar Matters
To a large degree, the supply of new municipal bond issues coming to market is predictable, as it displays strong tendencies at certain times during the year. States and municipalities tend to close out their fiscal years on June 30th. As a result, June is a heavy issuance month as well as September, October, and November. All else being equal, the increased supply during these times often causes municipal bond yields to increase, and therefore may provide a buying opportunity.
Tip 2: Rating Agencies Look At Too Limited a Set Of Data
BlackRock follows the same basic methodologies used by the ratings agencies to assess credit quality of municipal issuers. Quantitative models based upon the local economy, fiscal structure, and debt burden are used to access a municipal issuer’s capacity to pay their obligations, while qualitative factors, such as strength of management, that are more difficult to measure, are used to assess an issuers willingness to pay.
However, BlackRock also has its own internal “BLK” rating on every bond that it owns. The BLK rating incorporates more data than a traditional rating agency (such as S&P or Moody’s). Unlike the agencies that base their ratings upon degree of leverage and probability of default on a particular bond, BlackRock focuses on the margin of safety that an issuer will be willing and able to pay of its obligation on a timely basis, giving higher weighting to key socio-demographic measures. Since municipal borrowers are motivated by social and political objectives, compared to corporations that focus on maximizing cash flow, it is very important to understand local political process, the essentiality and structure of a particular bond financing, as well as the longer term outlook of the service area. On these issues, BlackRock is more proactive on investment decisions, while the agencies are typically reactive and tend to use a “wait and see” approach.
Tip 3: The Value Proposition Of In-State Bonds is Hard To Beat for High Tax States / but Avoid Puerto Rico
Peter Hayes specifically mentioned that California taxpayers (where the highest state tax income bracket is 10.3%) would have a hard time matching the value proposition of in-state bonds. If you buy an in-state municipal bond, you don’t have to pay Federal, state, or (where applicable) local income taxes on interest. California has the highest state income tax in the nation. Other high tax states with income taxes that can exceed 8.0% include Oregon, New York, Iowa, New Jersey, Iowa, Maine and Vermont. Peter did not comment on the attractiveness of these states’ bond issues. However, he did point out that California had a tremendous supply of bonds available for purchase at most times, which might not be true for smaller states. Also, he likes California’s large diverse economy and thinks the state’s bonds offer relative value compared to other similar rated municipal bonds. California muni bonds are a good investment for Californians because of their combination tax benefits, availability for purchase, safety and yield.
Typically, municipal bond buyers in high-tax states look at debt from Puerto Rico because the same tax benefits of in-state bonds and higher yield. Peter thought the credit risk on many PR bonds outweighed the benefits of extra yield. One of the concerns he has with Puerto Rico is that the economy is not diversified and focused heavily on tourism. (See our article on Puerto Rican Municipal Bonds for more on this)
Tip 4: Willingness To Pay is an Important Factor Often Overlooked by Bond Investors
Not everything can be captured by numbers. While a municipality may be able to pay its debt obligations, the citizens of the municipality may not be willing to pay the taxes or accept the cuts in services required to meet its debt obligations. When assessing the “Willingness to Pay”, Peter Hayes indicated that BlackRock considers a couple factors:
- How dependent is the municipality on the bond market to provide money for important projects? If the municipality frequently issues bonds, they tend to be very careful not to jeopardize this source of capital.
- What has the municipality done in the past during difficult economic situations? Have they been able to cut spending or increase taxes when the municipality has been in financial trouble.
Tip 5: Retail Investors Tend not to Pay Attention to a Bond’s Callability
The word Peter Hayes used was “Refunding” (in contrast to pre-refunding). Many municipal bond issues have call features in which the issuer can choose to call (buyback at a predetermined price) part or all of a bond issue at a specified time. Due to the extremely low interest-rate environment we are currently in, many municipalities might be thinking about calling their bonds, and issuing new bonds which pay a lower rate of interest. Although this varies greatly by issue, many municipal bonds have a potential call date 10 years after issue. In other words, you need to be very careful about buying or holding a bond that was issued several years ago. If you’re buying a bond using a financial advisor, you should ask them when the next call date is scheduled. If you are buying bonds through one of Blackrock’s mutual funds, you don’t need to worry about this issue. They will worry about it for you. You can learn more about yield to call here.
More from Peter Hayes
Municipal Market Update: Point of View with Peter Hayes
BlackRock Video: Video Municipal Market Update with Peter Hayes