Yields entice in muni sell-off
It’s a great time to be a buyer of high-quality tax-free municipal bonds.
Except that it might be an even better time in a week or so. Or several months from now.
When the state of California tries to raise $1.75 billion early next week in one of its periodic sales of general-obligation bonds, it is likely to have to pay the highest interest rates in four years, at least on securities maturing in 20 years or more.
California taxpayers, who ultimately foot the interest bill on the state’s bonds, can thank the credit-market mess that Wall Street has brought on itself and the rest of us.
Muni bond prices have plunged in recent weeks, driving yields way up, in part because investors are fleeing certain muni securities that were marketed as super-safe, short-term debt when in fact they were long-term securities.
Chalk up another brilliant stroke by the financial industry’s alchemists -- the same group of people who assured investors that AAA-rated bonds really could be created from a rank vat of sub-prime mortgages.
We’ll come back to the scene of the crime, but first let’s look at what may be an opportunity for investors who have cash to put to work and are hungry for a decent return on their money.
The plain-vanilla bonds the state will offer for sale Monday through Wednesday will finance voter-approved infrastructure improvements such as new schools, libraries and clean-water projects.
The bonds, as usual in such sales, will be offered in maturities of one year to 30 years.
Here’s the hook: Based on what the market was demanding Friday, California may have to pay north of 4.5% on 10-year bonds and north of 5.2% on 20-year issues.
Because the interest is exempt from state and federal income tax, those yields are equivalent to much higher rates on taxable bonds.
A married couple with taxable income between $131,451 and $200,300 this year would be in a combined federal and state tax bracket of 34.7%, according to the California Municipal Bond Advisor newsletter. In that bracket, a 5.2% tax-free yield is the same as earning nearly 8% on a fully taxable bond.
By contrast, a 20-year U.S. Treasury bond now pays 4.4%, which is subject to federal income tax but not state tax.
Mike Dawson, co-manager of the MFS California Municipal Bond mutual fund in Boston, says muni yields at these levels offer “absolutely tremendous value.”
Yet investors aren’t breaking down the doors to get at those interest rates. That may be because potential buyers fear a perfect storm at hand: a struggling economy, rising inflation and a burgeoning supply of bonds in the market coming in part from investors who are bailing out.
Any of those factors individually, or any combination, could drive muni yields higher from their current lofty levels.
The economy’s woes mean investors are growing more concerned about bond issuers’ ability to pay their bills.
Even in the case of issuers for which default is inconceivable (such as California), investors still will demand higher interest rates to compensate for what they perceive to be greater risk.
And given the mounting budget deficit California faces, it’s understandable that the market sees the state as a bigger risk.
As for inflation, it is Public Enemy No. 1 for bond investors because it erodes fixed-rate returns.
The U.S. consumer price index was up 4.3% in the 12 months through January largely because of soaring food and energy costs. If you think inflation will worsen, today’s bond yields may not be enough to make you feel good about locking in fixed returns.
Finally, there’s the issue of supply. When the market is loaded with bonds for sale but few buyers are stepping up, the result is that the prices of the securities drop. In turn, that means yields go up.
A flood of selling swamped the muni market in February. As bond prices have been marked down to try to entice buyers, investors in muni bond mutual funds have seen their share prices fall off a cliff.
Shares of the $14-billion-asset Franklin California Tax-Free Income fund ended at $6.83 on Friday, a loss of 5.5% in just three weeks. For a bond fund, that’s a painful hit.
Keep in mind that prices aren’t falling because muni issuers are defaulting on their bonds. This isn’t like the sub-prime mortgage-bond debacle in that sense.
But there is a connection.
The muni market’s troubles began late last year, when investors began to doubt the value of the guarantees provided on many muni issues by private insurance firms. Because those insurers are reeling from losses on sub-prime bonds they backed, it isn’t clear that they can meet other obligations in the long run.
Worries about bond insurance then caused investors to begin pulling away from a corner of the muni market that was designed by Wall Street’s alchemists.
Brokerages took long-term muni bonds and in effect turned them into floating-rate, short-term securities known as auction-rate bonds and variable-rate demand notes. But the trick worked only if investors kept showing up to bid for the bonds when their rates reset every seven to 35 days.
As doubts about bond insurers mushroomed, some investors who wanted only the highest-quality short-term debt suddenly balked. In the last few weeks, many of the auctions used to reset yields on the bonds failed to attract enough new money. So what was short-term debt became open-ended.
That has triggered “penalty” interest rates for the bond issuers. Not surprisingly, many of them now want to refinance. But to retire that debt they’ll have to issue new bonds, adding more supply to the market.
There’s a lot more to this story. But the upshot is that the muni market remains badly out of joint.
“It’s hard to tell you that we’re at the bottom,” Dawson said. “It doesn’t feel like it’s over yet.”
There’s a new threat: Some of the selling that has hammered munis can be sourced to hedge funds that bought the bonds with borrowed money as a way to juice their returns.
The risk in buying investments on credit is that if the value of the securities tumbles, the investor can face a margin call -- meaning a demand by the lender to put up more assets to back the loan. At that point, the investor may have little choice but to liquidate holdings to pay off the loan.
Liquidation sales dropped huge numbers of muni bonds on the market this week, traders say.
For investors, of course, “One man’s problem is another man’s opportunity,” as Joe Deane, who manages about $8 billion in muni funds for Western Asset Management, notes. He said he wasn’t sure he’d be buying California bonds in the sale next week but added that he expected to be taking a good look at them.
For individual, buy-and-hold type investors, there’s no question that muni yields have appeal at these levels. That won’t change even if the yields become more appealing in the next few months because the market sells off further.
If you’re interested in the California deal, specifically, the state is offering retail investors the chance to put in orders Monday and Tuesday via brokerages, before institutions bid Wednesday.
For more information, check out the state’s website, www.buycaliforniabonds.com.
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