Potential Opportunity In the Municipal Bond Market

There is something strange going on in the Municipal Bond Market and it may well be another opportunity for resourceful investors to buy tax advantaged cash flows at attractive prices. There has been a selloff over the past two weeks and as prices decline, yields get more attractive.

• A confluence of events seems to have sparked a selloff in the municipal bond markets.

o Treasury yields rose, which led some investors to want to sell as treasury prices went down.

o A massive amount of municipal bond supply came into the market, about $39 billion for the period November 1^st through November 19^th.

o A changing of the political guard makes the anticipated tax hikes slightly less certain, which takes the focus off tax advantaged municipal bonds.

o The municipal bond market is more inefficient and fragmented now than it was prior to the 2008. The financial crisis and the collapse of both municipal bond insurers and bond credit rating agencies have affected the muni-market.

• If you can buy a 10 year AA rated, essential services revenue municipal bond with a yield of 4%, your taxable equivalent yield for someone in the 35% Federal Income tax bracket would be 6.15% (if state taxes are zero), or 6.80% for a California resident paying the maximum CA state tax rate.

US Muni General Obligation AA (white) yield curve 11/26/2010 (left) and 10/26/2010 (right)

US Muni General Obligation A+ (Orange) yield curve 11/26/2010 (left) and 10/26/2010 (right)

• To put a taxable equivalent yield of 6.15% to 6.80% into perspective, the annualized return for the S&P 500 US equity index over the last 15 years (10/31/1995 to 10/29/2010), has been 6.74% before taxes (source Bloomberg).

• There are dangers that need to avoided in the municipal bond market.

o Indirect investment vehicles, ETF’s, mutual funds and closed end bond funds will most likely have more severe price reactions to changes in yields and interest rates.

o According to a Wall Street Journal article on 11/26/2010, “Investors pulled an estimated $4.78 billion out of municipal bond mutual funds last week.”

o Indirect investment vehicles do not offer investors the opportunity to hold to maturity and realize a fixed yield to maturity.

o The mob mentality that contributes to these massive inflows and outflows to pooled investment vehicles can create opportunities for individual bond buyers

o According to a Wall Street Journal article on 11/26/2010, “Retail or individual, investors hold an estimated two-thirds of outstanding bonds in the $2.8 trillion muni market, through individual accounts and mutual funds. The rest are held by large institutional investors.”

• Building a portfolio of individually selected municipal bonds, provide investors with attributes not available in pooled (indirect) investment vehicles.

We buy municipal bonds for three fundamental reasons:

1. Return of Principal at maturity – Safety

2. Contractual Cash flow payments – Federal Tax Free Income

3. A known return or yield to maturity, if held to maturity – the ability to ride out market fluctuations with the confidence that you are earning a return and that your investment principal is highly likely to come back to you.

We are not overly worried about the safety of the Municipal Bond Market in general.

• The municipal market is estimated to consist of 20,000 plus outstanding debt instruments worth $2.7 trillion. Over the last 10 years annual issuance has ranged from $287.2 billion to $429.9 billion per year. The 10 year cumulative default rate through 2009 for all rated municipal bonds, including those rated below investment grade, ranges from 0.04% to 0.29% based on reporting from all three major rating agencies.

• There is an excellent Fitch research report dated November 16, 2010, U.S. State and Local Government Bond Credit Quality: More Sparks than Fire, contact us for a copy.

Municipal Bond Worries, More Headline Risk than Real Risk?

Conclusions:

· We expect to see more dire headlines and negative news stories about municipalities, but we firmly believe that the actual risk of default for the high quality municipal bonds that we favor in our client portfolios is very low.

o On February 18th, 2010 the Wall Street Journal printed an article entitled, “Muni Threat: Cities Weigh Chapter 9.” The article questions the safety of municipal bonds and is distressing to investors that view municipal bonds as the safe money in their asset allocations.

· Historically defaults in municipal bonds are rare, although with almost 90,000 issuers there are always some issuers with financial troubles, in both good and bad economic times.

· We believe Municipal Bonds will remain relatively safe investments and that Municipal Bond defaults will not increase significantly in this recession.

· We continue to incorporate what we believe are prudent risk management techniques into our approach to the management of municipal fixed income portfolios

The Economic Pressures of the Recession are Real for Municipalities and States

In a January 28th, 2010 report from the Center on Budget and Policy Priorities, there are some discouraging statistics. There are 48 states that face budget shortfalls in 2010, and the combined total state budget shortfall for fiscal year 2010 is $194 Billion. To put that into perspective, during the last recession from 2002 to 2005, the maximum total state budget shortfall occurred in 2004 and was $80 billion. It is interesting to note that in the recession of 2002 to 2005, there was no significant increase in municipal bond defaults.

Is this recession different and will we see a significant increase in the default rate for municipal bonds?

I have no doubt that these budget shortfalls will force elected officials to make some difficult decisions as they cut services to bring their spending in line with revenue realities. Many elected officials will be forced to make these tough decisions because most municipal governments are required to pass balance budgets.

When it comes to the State issuers, forty-nine of the 50 states require balanced budgets. The only state that does not require a balance budget is Vermont. According to the Center on Budget and Policy Priorities report, cited above, “Over 30 states have raised taxes to at least some degree and in some cases quite significantly.”

Elected officials, even under immense financial stress, have historically made sure that their debt service obligations are met so that they can maintain a default free record and have continued access to financing for the construction of critical infrastructure items like schools, roads, and bridges.

Although each State or Municipality has a different ratio of debt service to revenue, overall the amount required for debt service is generally low compared when compared to other budget items.

· According to a report by the Treasurer of the State of California, one of the states often cited in the media as being in dire straits, California has $83.5 billion of outstanding long term debt as of December 1, 2009 and the debt service for 2010 is $6.09 billion on estimated revenues of $88.09 billion. The debt service ratio is 6.91%. It should also be noted that California law puts repayment of general obligation debt second in line to receive payment, behind only funding for the schools.

We believe the Treasurer’s report for the State of California proves our case. Even with lower projected tax revenues the state of California should be able to pay the 6.91% of their projected revenues to service their outstanding municipal bond debt. The findings of our research are in direct contrast to the image generally portrayed in the media, where the State of California is often mentioned as a state that investors should be worried about.

Each time we research the municipal bond issuers that we either own or are likely to own their bonds, we have come to the same conclusion. Tax revenues are positively correlated to economic growth, and when the economy is contracting tax revenues will decrease. A decrease in tax revenues does not necessarily lead to a higher probability of default. As we delve deeper into the details, we generally conclude that tax revenues are unlikely to decrease to the point that would cause a noticeable increase in municipal bond defaults.

The Kingsbridge PWM Approach to Managing Municipal Bond Portfolios

Controlling risk is very important in our approach to municipal fixed income management. We own municipal bonds because of the tax free income that is a result of the contractual cash flow payments and the promised return of principal. It is not possible to completely eliminate the risk of an issuer defaulting on their promise to pay you ongoing coupon payments and to return your principal at maturity. But, there are portfolio construction techniques that we believe will lower your overall risk from defaults.

· Not all municipal bonds are the same. We focus our efforts on buying General Obligation bonds, Essential Services Revenue bonds, and Education bonds.

· The most significant classification of municipal bonds lies between General Obligation bonds and Revenue bonds.

· General Obligation bonds may be generally considered safer than Revenue bonds for the simple reason that the interest and principal is backed by the full faith and credit of the issuer.
With Revenue bonds, the principal and interest are dependent on the revenues paid by users of the facility or service financed.

· We limit your exposure to any one issue to a maximum of 5% of your bond portfolio. This technique means that a default by one particular issuer should have only a minor impact on your overall portfolio of municipal bonds.

· If your bond portfolio is a National Multi-State Portfolio, we limit your exposure to any one state to a maximum of 15% or your bond portfolio. This technique gives us some version of geographic diversification.