Wednesday, February 2, 2011

Muni Selling Pressures Create Opportunities

When investing in bonds for my clients, there are two themes that I keep in mind.

First, I continue to believe that the bigger risk for most investors is that interest rates could move lower, not higher. Yes, I understand that commodity prices are moving higher, but I still think that the overall economic picture is one of disinflation, if not deflationary, trends.

The second theme I am following is that I believe that municipal bonds are extremely attractive relative to most other alternatives in the capital markets. I understand the huge financial problems facing state and local governments, but I also think that solutions will be found.

To be honest, however, most clients do not agree with me on either theme.

The overwhelming consensus opinion is that interest rates will be moving sharply higher sooner rather than later. Most cite the huge federal budget deficits, combined with very generous Fed policy, as reasons that the "bond market vigilantes" will eventually demand higher rates.

However, municipal bonds have been very much in the news, and investors in municipal bond funds have been fleeing the sector.

A recent column written by Randall Forsyth in Barron's cites some work done by Barclays Capital which points out that investor fears on municipal debt has driven municipal bonds guaranteed by corporate borrowers to higher interest rates than taxable bonds issued by the same corporate borrower.

Here's an excerpt:

For instance, the Barclays analysts found a Dow Chemical (DOW) IDR due 2033 yielding 6.25% tax-free while a Dow corporate due 2029 yielded 5.67%. The chemical company's debt is rated triple-B-minus by Standard & Poor's, a single grade above junk. Other Dow IDRs yield from 58 basis points 172 basis points above comparable Dow corporates. (A basis point 1/100 of a percentage point.)

An International Paper (IP) tax-exempt IDR due in March 2014 yielded 3.50%, above the 2.94% on the taxable bond due June 2014. Their ratings Baa3 by Moody's, its lowest investment grade, and triple-B by S&P

Some Muni Yields Exceed Similar Corporates -

So not only are municipal bonds yielding more than Treasurys across most of the maturity spectrum but munis are often yielding more than corporate bonds of the same credit.

In my opinion, such indiscriminate selling usually spells opportunity, and I think the muni market today represents a good buy.