Municipal bonds continue to rally

(MoneyWatch) 

The municipal bond market continues to defy the experts, with minimal defaults and a strong rally. According to research firm Municipal Market Data, there were only $6.1 billion in defaults last year (0.1 percent of the muni market), of which $3.5 billion (almost 60 percent) represents American Airlines special facility bonds. (The company filed for Chapter 11 bankruptcy in December.)

The municipal credit outlook continues to improve as tax revenues for state and local governments recover. The third quarter saw year-over-year tax revenues rise 4.1 percent, the eighth consecutive quarterly increase on a year-over-year basis. Property, sales, and personal income tax receipts also continue to improve. Total tax receipts are now above pre-recession levels, though individual income tax receipts haven't fully recovered. Such improvement, coupled with expense reductions and renegotiated labor contracts, has allowed states to rebuild their reserves. However, at less than 4 percent, they remain well below the 10 percent level of 2006.

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Because of this rebound, new issuance of municipal bonds remains slow. The reduced supply helped fuel the municipal bond rally we saw in 2011, and the rally continued into January. The spread between 10-year Treasuries and 10-year AAA municipal bonds, which started the fourth quarter at more than 115 percent, is now below 90 percent.

This healthier environment calls to mind the forecast Meredith Whitney made at the end of 2010, when she predicted municipal bond defaults totaling hundreds of billions in 2011. This serves as a reminder of why it's often wise to tune out the dire predictions of investment gurus.

[smpatel100]

Larry,

Great article and your insistenance on using highest grade bonds is clear. Along those lines, does it make sense for individuals to buy funds specific to their state to avoid both federal and state taxes on them? Could this lead to poor bond quality or term (longer than usual) issue? Specifically, for example PRVAX with the yield of 3.94%, YTD return 2.01%.

I understand your normal position around 500k portfolio and laddering with individual bonds but above is for lesser amt than that.
regards,

[LarryswedroeCBS]

The answer is it depends. WE only use bond funds for small accounts and for "cash reserves" to rebalance, etc.

The problems with funds are many. Though they do provide diversification benefits.

a) investors make mistakes of thinking that they should only buy there own state's bonds. That is not necessarily the case. Often we find you can get higher returns by buying other state bonds, even after the tax difference.
b)parts of the curve may be more attractive to use taxables like CDs. That is certainly the case now and we have been buying taxables for many clients even in the highest bracket. And now there are some as far out as 10 years (Goldman Sachs)
c)Of course you can run into issues of maturity risk if active fund and big time credit risk. Note that the higher the cost fund the riskier the bonds they typically buy in order to overcome their high fees.
d)then have concentration in single state issue--though can diversify to other issuers than the state itself, still likely prudent to move beyond state

And as to national funds, they are particularly poor because why would a Florida investor for example, with no state tax want to own NY, Cal, or other state's bonds where the tax rates are high and thus demand high and rates low.

Those are among the reasons we build individual bond laddrs for our clients, but there are others including ability to harvest losses at individual security level. But we can buy at institutional prices, the same or very similar prices as to what say Vanguard pays when it buys. And we have some advantages in that we can buy up smaller offering which can sometimes be bought with higher yields. A big fund won't bother with such a transaction.

I hope that is helpful

Larry

[sengssk]

Some munis are more equal than others:

http://www.bloomberg.com/news/2012-01-06/illinois-rating-lowered-to-a2-by-moody-s-with-32-billion-of-debt-affected.html

[LarryswedroeCBS]

Yes absolutely
I only recommend buying bonds that are AAA/AA with possible exception for A if 3 years or less. And even if have a high rating, but from sectors that have historically poor default histories (multi family housing, health care, industrial bonds, etc) we would avoid.If interested in learning more would recommend reading Only Guide You'll Ever Need for the Winning Bond Strategy.
Hope that helps
Best wishes
Larry