For Now, Muni Holders Can Just Tend the Grass
Some investors seem to spend more time watching grass grow than keeping track of their municipal bond funds. And it’s not because grass watching has emerged as the latest spectator craze.
Rather, muni bonds and the mutual funds that hold them usually don’t require a lot of attention. Usually, you can count on munis to deliver steady, tax-exempt income with a minimum risk of default.
Some municipal issues are backed by the taxing authority of cities and states. Others are bolstered by the revenue generated by a specific project, such as a toll bridge or sewer system. Either way, most issuers normally have the wherewithal to pay off their debt as promised. As a group, munis are arguably the second-safest category of bonds, behind government securities.
However, these aren’t normal times. The threat of recession hangs over the economy. A strong downturn would increase the number of failures, in the private and public sectors. Some high-yield, or “junk,” municipal issues could get into trouble, just as dozens of marginal corporate bonds have defaulted.
If you own a muni bond fund, especially one of the 27 high-yield portfolios, should you sell? Not necessarily. But at the least, you should review your holdings to make sure you’re comfortable with the risk.
“The worst of the munis aren’t nearly as bad as the worst of the corporate junk bonds,” argues Zane B. Mann, publisher of the California Municipal Bond Advisor newsletter in Palm Springs. With the exception of a few, relatively insignificant categories of bonds, such as those issued for nursing homes and raw-land development, Mann doesn’t think high-yield munis carry much default risk at all.
That sentiment is shared by William T. Reynolds, who manages several muni bond funds for Baltimore-based T. Rowe Price, including the company’s Tax-Free High-Yield portfolio. Compared to junk corporates, lower-rated munis are less likely to have gobs of debt on their books, Reynolds says. Besides, the high-yield muni category includes a large number of solid bonds that don’t have a rating--good or bad--simply because their issuers didn’t want to pay for one.
In addition, as Reynolds points out, many funds with the “high-yield” designation are allowed to invest in better-quality issues, too. For instance, lower-rated munis represent less than 30% of his fund’s holdings.
But this doesn’t mean that junk munis are out of the woods. In a recession, investors flock to safety. As a result, they will tend to bid down the prices of lower-rated bonds relative to others. Thus, investors can see their funds lose market value, even if the number of defaults doesn’t rise much.
D. Tyler Jenks, director of research at Kanon, Bloch Carre & Co., a Boston-based mutual fund research and money management firm, considers this a real danger at the moment. With roughly 10,000 different muni issues, it can be hard for fund managers to get accurate daily prices on all of their holdings. “Many junk bonds--both corporates and municipals--really act like over-the-counter stocks that don’t trade very often, with wide (price) spreads,” he says.
A manager who had to sell a big block of an obscure issue--to meet shareholder redemptions, for example--might receive an unexpectedly low price, Jenks argues. He believes that many fund managers would have trouble selling bonds at the prices they’re carried at in the portfolio. The assets of some high-yield muni funds might be overstated by perhaps 15% to 25%, he suggests.
Time will tell if Jenks’ evaluation is correct, but so far investors don’t seem overly concerned. Although nearly all types of domestic bonds have had trouble lately, lower-rated munis have held up relatively well. For the 12 months ended Aug. 31, high-yield municipal bond funds fared a fraction better than muni bond portfolios in general, returning 4.9% on average, including dividends, according to Lipper Analytical Services.
Compare this to the corporate sector, where investors have been avoiding junk securities like the plague. According to Lipper, higher-rated corporate bond funds returned 4.7% during the same period (again including dividends), as opposed to an average loss of 8.1% for their junk counterparts.
Most muni funds primarily buy “investment grade” bonds--those rated at or above BBB or Baa (see accompanying chart). However, more than two dozen portfolios stick with top-tier issues--those rated AAA or Aaa. These “insured” funds offer the greatest safety against default risk.
On an insured muni, a third party guarantees the timely payment of interest and principal. This pledge gives the bond an AAA rating, even if the issuing municipality isn’t top quality. Higher ratings allow municipalities to issue bonds at lower interest rates--an economical feature. On the other hand, insurance isn’t free, which explains why most municipalities don’t seek it. Sometimes, a mutual fund will buy uninsured bonds and pay extra to have them covered, thereby boosting their value.
It’s important to realize that insurance won’t protect munis from price fluctuations before maturity, which means you can still lose money on these securities. But insurance removes the element of default risk. “From that perspective, it makes investors feel good,” says Bill Loring, manager of an insured portfolio and three other municipal bond funds for the Colonial Group in Boston.
Of course, any pledge is only as good as the party making it. That goes for muni bond insurers, who have yet to face a major scare. But Loring describes the handful of companies providing insurance as strong, well-capitalized outfits that typically have hedged their bets by reserving coverage to sound municipalities. “The bonds that don’t need insurance are generally those that get it,” he observes.
Insured and other top-rated bonds yield less because of their greater safety. But currently, the differential isn’t as wide as it had been. “At the moment, insured munis are reasonably good buys,” Loring says. The reason: More insurers have entered the business, and competition has driven down the cost of coverage.
Mann also likes insured munis at current prices. In previous years, he says, an insured bond might yield a full percentage point less than one rated A. Now, that gap has shrunk to about a quarter of a point. “In the past, I thought insured munis weren’t worth it, but now there’s not much of a difference in yield.”
On the other hand, Mann observes, junk munis are only yielding about 1 percentage point more than high-quality bonds, down from about 3 points in years past. “It doesn’t pay to buy them,” he says.
In short, now appears to be a good time to stick with high-quality municipal bonds and bond funds, especially if you see a recession lurking in the grass.
BOND RATINGS: FINANCIAL SHORTHAND
Bond investors share a common concern--uncertainty as to whether they will get their money back, with interest. That’s where independent credit-rating services come in. These companies evaluate the financial strength of bond issuers and summarize their findings in a simple grade. Thus, investors can easily identify bonds that might have trouble paying off.
The ratings can also be used to evaluate fixed-income mutual funds. A fund’s prospectus outlines the investment parameters that the portfolio manager may follow, and periodic reports list the types of bonds held and in what quantities.
Here are the gradations given municipal and corporate bonds by Standard & Poor’s Corp. and Moody’s Investors Service, the two largest rating agencies.
S&P; Rating: AAA Moody’s Rating: Aaa Description: Issuer has extremely strong capacity to pay interest on time and repay principal. Insured munis carry one of these ratings. S&P; Rating: AA Moody’s Rating: Aa Description: Very strong capacity to pay interest and repay principal. S&P; Rating: A Moody’s Rating: A Description: Strong capacity. S&P; Rating: BBB Moody’s Rating: Baa Description: Adequate capacity. Bonds rated at this level or above are considered “investment grade.” S&P; Rating: BB Moody’s Rating: Ba Description: Speculative ability to pay interest and repay principal. Bonds rated at this level or below are deemed high-yield, or ‘junk,’ securities. S&P; Rating: B Moody’s Rating: B Description: Low grade, speculative ability. S&P; Rating: CCC Moody’s Rating: Caa Description: Poor grade, speculative ability. S&P; Rating: CC Moody’s Rating: Ca Description: Highly speculative. S&P; Rating: C Moody’s Rating: C Description: This grade describes bonds that might already have stopped paying interest. This is the lowest rating on Moody’s scale. S&P; also has grades of CI, for bonds that have missed interest payments, and D, for issues in default. For more precise evaluations, S&P; sometimes adds a + or - to a letter grade, while Moody’s might add a 1. For example, a bond rated A+ or A1 would outrank an A.
