Money managers play defense in their municipal portfolios - Investment News

A couple of days ago one of my clients asked me to sell a few municipal bonds in his portfolios.

No problem, I said - rates have fallen a lot, and we can probably realize a few capital gains.

But when I took my orders to our bond desk, and got the bids back, I was surprised.

My client's municipal bonds - one a general obligation of the state of California, and the others New Jersey revenue bonds issued by a couple of the largest medical facilities in New Jersey - were largely shunned by the bond dealer community. The bids in fact reflected yields well north of 5%.

If I had sold the bonds, my client would have realized a significant capital loss, we decided to simply hold on.

What's going on?

Turns out that lower quality, investment grade municipal bonds are being avoided by most clients, even though it is hard for me to imagine a scenario where a credit like California (currently rated single-A) would not pay its obligations to bondholders.

Then I ran across this story in Investment News, where several municipal bond specialists were quoted as saying that they were focusing strictly on the highest quality bonds. Frankly, this to me does not seem to make any sense.

Unless you are envisioning total financial Armageddon, it is hard to believe that the entire municipal bond market will be defaulting at the same time. True, there may be credits that have problems, but if you have the time and resources to manage a municipal bond portfolio correctly, it would seem that opportunities abound.

Let's take the California issue as an example. My client's bond matures in 2013, and carries a 4.75% coupon. At a market price of 100, this is yield-to-maturity of 4.75%. US Treasury notes in 2013 yield 0.80%. Any way you look at it, an investor would be much better served by buying the state of California paper, although the Cal paper has less liquidity.

Even in the Great Depression of the 1930's, there were no state defaults. The percentage of municipal debt that has ever defaulted has been very low for numerous reasons, not the least of which is the simple fact that states and most municipalities cannot go into bankruptcy.

I'm not saying that municipal budgets don't face some serious issues. However, it seems to me that this is the time that a true investor can step up and demonstrate their ability to analyze municipal credits.

Back to the article. This is fairly typical of the mindset of some municipal managers. Let me pick on one manager from a firm here in town (I have shortened the names):

One of the biggest risks that muni bonds face is the public perception that there is about to be a wave of defaults among municipalities, Ms. T. said.

The potential risk is that as rumors about the pending fall of municipalities gains traction, it will cause liquidity problems for the muni market because that liquidity is so reliant on retail investors, she said.

Regardless, S. has spent the past several months unwinding the credit risk of its muni bond funds, Ms. T. said. The firm has sold out of the lowest-quality bonds.

S. also has begun significantly underweighting general-obligation portfolios, Ms. T. said.

“It's a legitimate concern that credit quality is deteriorating,” she said. “But we don't think we will see widespread defaults in the general-obligation market.

So let me understand what Ms. T. is saying. Yes, she says, there seems to be the perception that there is going to be a wave of defaults. But, no, she knows this is not likely to happen.

But we're going to sell anyway, says Ms. T, because investors are calling us. Moreover, even if our clients are "buy-and-hold" investors who have no intention of selling their bonds prior to maturity, we're selling because the lower quality bonds will be less liquid.

Geez - talk about your head-scratcher.

Fortunately, there seem to be other managers who look at today's market situation for what it is; namely, an opportunity for strong research and insightful managers to demonstrate their skills:

At the same time, many managers, such as Eaton Vance Corp. and Nuveen Investments Inc., are stepping up their research efforts to sniff out the potential for credit risk at different issuers.

“With most of the insurers being downgraded, there needs to be more research on all the bonds in the universe,” said Cindy Clemson, co-director of muni investments and a portfolio manager on Eaton Vance's muni bond team. Ten percent of new muni bonds issued are insured, down from 50% in 2008, according to the Municipal Securities Rulemaking Board.

Eaton Vance recently hired a re-searcher and plans to hire another analyst to bring its total team to nine people to address the increased need for vetting new muni bonds.

The fear present in the municipal bond market today is, I believe, an opportunity to be exploited, much as we saw in the fall of 2008.

Money managers play defense in their municipal portfolios - Investment News