Tuesday, November 30, 2010

Attention Pension Plans: Swap Corporate Bonds for Long-Dated Munis


I know what you're thinking: Doesn't Random Glenings realize that municipal interest is tax-exempt, and therefore is not appropriate for tax-deferred accounts?

Well, yes, but once in a while investors get an opportunity to take advantage of year-end supply/demand imbalances in the muni market. If this plays out the way I suspect it will, swapping from corporates to munis now, and reversing the swap in the first part of next year, should give a nice bump in total returns in bond portfolios.

Merrill Lynch put out a report a couple of days ago which provided some timely data on just how much the muni bond market is under pressure.

As I wrote last week, the muni market is currently being swamped with new issue supply. At the same time that municipalities are rushing to market to try to raise funds prior to year-end, investors have become skittish on municipal bonds.

According to Merrill Lynch:

Bond mutual funds have been experiencing very light flows for several weeks now, and are now experiencing strong outflows. Lipper FMI reported outflows of $3.1 bn. from all muni funds, the largest weekly outflow on record.

Meanwhile, while new issue muni supply has not yet hit record levels, it is still pretty heavy: Merrill indicated that about $17 billion in new muni supply hit the markets last week, which is one of the highest amounts in some time.

So this has left muni bond yields at very attractive levels.

Long muni general obligation bonds (GO's) are trading at close to 95% of long A-rated corporates, the cheapest level ever in the history of Merrill's data base. Even if you exclude California GO's (which trade at higher yields than most other states), long muni GO's are still trading close to 90% of A-rated corporates.

Normally long munis trade at 75% or less of the yields of long corporates.

So let's put some numbers on this. Let's just say you have the choice of buying a 20 year corporate bond yielding 4.50% or a muni GO at 4.25% (or about 94% of the yield of the taxable corporate).

Now, let's assume that the corporate/muni ratio returns to historic norms, or around 75%, by the end of March 2011.

If all else has stayed the same (i.e. corporate rates are unchanged), the total return for the corporate will be approximately 1.5% (you've basically earned the coupon).

Meanwhile, the 20 muni GO would now yield 3.4%. This yield decline from 4.25% today to 3.4% by the end of March 2011 implies a capital gain of more than +12% in 4 months.

When you add the 1.4% in interest from the muni GO, your total return becomes +13.4% on the muni vs. +1.5% on the corporate.

Moreover, if the trade takes longer to work than I expect, well, you're still earning a yield well above the 10-year Treasury, and better than many higher rated corporates.

What about credit risk?

There's been lots of talk about municipal credit issues, which is justified. But the fact remains that state GO's almost never default for the very simple reason that states need access to the credit markets, and that access would be lost if a state defaulted. Even in these financially stressed times, Merrill notes, the muni default rate this year has been 1% of new issue volume, and only three Chapter 9 bankruptcy failings (and all by small municipalities).

That sound you hear is Opportunity Knocking.