Markets

5 Things You Should Consider Before Buying Municipal Bonds

By Larry Swedroe

Updated on: October 17, 2011 / 11:31 AM EDT / MoneyWatch

With the turmoil in our economy and the dire bond predictions of people such as Meredith Whitney, many investors have become nervous about the municipal bond market. I thought it would be helpful to have Jared Kizer, my Alternative Investments co-author and the director of investment strategy at my firm, share our bond-buying parameters with you. While we certainly can't guarantee that following these parameters will keep you safe, our clients have never experienced a default on a bond we've purchased, even in the 2000-2002 and 2008 crises. Here are his thoughts.

Since the recession that began in December 2007, many investors have become concerned about default risk in the municipal market. While that market has generally held up very well, and we believe many in the financial media have exaggerated default risk, we want to outline the process we use to manage credit risk in municipal bond portfolios.

There are five key elements to our process:

Assessing the underlying rating of the issuer assigned by Moody's and Standard and Poor's
Determining the bond issuer's sector
Reviewing the annual revenues of the issuer
Analyzing information obtained through Bloomberg on issuer financials and current news
Assessing the credit risk the market assigns to the bond

Photo courtesy of EnergeticNYC on Flickr.

Next: Assessing the Rating

Assessing the Rating The underlying issuer must be rated either A, Aa or Aaa if the security has less than three years to maturity and Aa or Aaa if it has three or more years to maturity. One of the reasons is that the correlation of bonds to equities increases as the credit rating decreases.

Note that we focus on the underlying issuer's rating and not the "insured" rating. This strategy has helped us more effectively manage credit risk in client portfolios, because the insurance companies that have historically insured municipal bond default risk were largely crippled by the subprime mortgage market meltdown, making the insurance worthless in many cases.

The purpose of this ratings screen is twofold:

First, despite the bad press that rating agencies have received, nonrated bonds have historically defaulted at much higher frequencies than rated bonds.
Second, the diversification benefit of fixed income tends to decrease as you move from Aaa down to lower ratings.

Photo courtesy of Maguis & David on Flickr.

Next: Determining the Sector

Determining the Sector We require that the bond is from either the general obligation or essential service revenue sectors of the municipal market.

These two sectors historically have had much lower default rates than other sectors, such as health care and housing municipal bonds. For example, from 1970-2009, Moody's reports that there were 54 defaults on municipal bonds that it had rated and only three were general obligation bonds. The bulk of the defaults were from the health care and housing sectors, which are sectors that we don't buy.

Photo courtesy of qwrrty on Flickr.

Next: Reviewing Revenues

Reviewing Revenues For general obligation bonds, the issuer must have at least $50 million of annual revenues.

The purpose of this screen is to reduce exposure to smaller municipalities that generally have less ability to maneuver through difficult times. They're also more sensitive to outlier events, such as large lawsuit judgments that may be easier for larger municipalities to manage.

Photo courtesy of respres on Flickr.

Next: Analyzing the Information

Analyzing the Information We use Bloomberg's data services to analyze the municipality's balance sheet, access relevant ratings reports and read any current news on the municipality.

This helps us understand the rating agency's perspective on the municipality and whether there are any financials or news that leads us to believe the agency rating is overstating the credit quality of the issuer.

Photo courtesy of .Martin. on Flickr.

Next: Comparing Yields

Comparing Yields Before purchase, we compare the yield on the bond we're considering with yields on the highest-quality municipal bonds.

We refer to this as the "market test." A hypothetical example should help clarify the value of this step. Let's say we know a five-year municipal bond of the highest credit quality is yielding 2.0 percent. If we're considering buying a municipal bond that satisfies all the other criteria but is yielding 2.8 percent, this indicates to us that the market is pricing a lot of risk into this bond, so we'll generally avoid purchasing these bonds.

A municipal bond is eligible for purchase once it has met these five criteria. While this process doesn't ensure that we'll avoid all defaults, we believe it greatly reduces the likelihood of a bond default. In practice, we've never had a default on a municipal bond that we have purchased, which speaks to the value that the above process has provided.

Photo courtesy of hans s on Flickr.
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