Cheap Munis, Not Detroit
David R. Kotok
Cumber July 22, 2013
We thank Michael Wilson of Morgan Stanley Wealth Management and FactSet Research Systems for a compilation of returns. Michael’s commentary in July talked about how “There was no place to hide in fixed income.” We agree, although we think hedging dampened volatility so that the damage was minimized.
Michael’s compilation of returns from May 1, 2013, close to the June lows in various markets reveals that all categories of fixed income had negative returns during this brief, less than two-month, period of time. The returns were as follows: bank loans down 0.45%, US short-term down 1.34%, US Treasuries down 3.46%, US high-yield down 4.48%, international bonds down 4.71%, global high-yield bonds down 5.04%, US municipals down 5.47%, US investment-grade down 6.30%, global inflation-linked down 8.15%, US TIPS down 9.73%, and emerging-market debt down 13.05%.
Clearly, bonds suffered a rout. Any bondholder who looked at the June 30, 2013, statements saw the effect of the global sell-off in fixed income. The sell-off did not happen in the US alone, and it was not unique to a specific sector. There was a broad and wholesale abandonment of fixed-income markets. The strategic impact was to force liquidation by holders, hedge funds, mutual funds, and institutional structured finance. All the action was on the sell side.
The construction is simple. When mutual funds as a group are getting redemptions, all of them become sellers. That is what happened in the bond sell-off. There were also some hedge funds and structured finance agents in some bond dealer-supported institutions that failed and had to be forced or liquidated. Rumors exacerbated the sell-off.
When such bond sell-offs occur, buyers stand aside and let the blood flow. We were one of those.
Now what happens after this rout? Bond markets start to recover; things start to normalize; and liquidity returns to the markets. There are now questions about institutional liquidity because of rule changes dealing with the capital necessary for banks and dealers to support their inventories. Essentially, liquidity provided by that capital is dry, and the basis on which inventory positions can be held by dealers is limited.
In our view, this situation creates tremendous opportunity in some of the bond-market sectors. We have written many times about how the highest-grade US tax-free municipal bonds are being priced in outrageous bargain structures. The entire curve of tax-free municipal bonds is now trading above the yields of taxable US Treasury obligations. We are making this comparison using the MMD scale versus the Treasury scale. We examine and compare these measures every day. We look at the spreads between tax-free and taxable bonds and compare them at the highest credit quality. This we do in order to remove the issue of default or credit risk from the calculation.
We are not talking about comparing Detroit tax-free bonds with Treasury bonds. There is no comparison. Detroit is a mess, in default – the latest poster child of financial trouble. The Treasury is a riskless US obligation subject only to political whim with regard to the extension of the debt limit. We presume that the US Treasury obligation is default-free. We have obtained permission to post Natalie Cohen’s (Wells Fargo) excellent analysis on Detroit as a guest piece in the Special Reports section of our website. The link is: http://www.cumber.com/content/special/detroit_public_pensions.pdf Readers may find this superb work of assistance as they sort through Detroit-related issues. We also have our research colleague Michael Comes’ Bloomberg Radio interview about Detroit on our website. The link is: http://www.cumber.com/content/special/mcomes.wma
Let’s get back to the matter of Munis being very cheap. Take the true and natural AAA credits available in the municipal bond market and compare them with Treasuries. The tax-free bonds yield more than the taxable Treasuries do. These bonds come from a sector, category, or subsector of tax-free municipal bonds that have a history of zero defaults in the last century. The comparison is almost as close as apples to apples. The US Treasury obligation is technically a superior credit to a natural AAA tax-free municipal bond, but not superior by very much. History is 100% on the bond buyer’s side when it comes to this debate.
What do we mean by a true and natural AAA credit? An example might be bonds issued by the state of Utah. Those bonds have particular budget coverage and requirements under Utah law; furthermore, they have an unblemished history of making all payments in a timely way. It is almost inconceivable that the state of Utah would default on the true AAA credit of its state’s general-obligation bond.
Another example of a tax-free bond in that category would be an education bond issued by Yale University, also a true AAA credit. Let’s think about it for a minute. The university has been there for centuries and has a huge endowment fund. Its credentials as an academic institution are paramount and well established. It is almost inconceivable that Yale University would default on its debt obligations. Well-financed as it is, Yale does issue bonds under certain structures. There are Yale tax-free education bonds.
When you compare the performance of Yale, the state of Utah, and similar credits with the US Treasury curve, you are very nearly comparing apples to apples in terms of their creditworthiness.
The present pricing of tax-free bonds makes sense only if we happen to think that the income tax code of the US is going to be repealed. The present market dysfunction is irrational. Such pricing would work only if there were no advantages to a tax-free bond versus a taxable bond. Only dysfunction can explain why these high-grade tax-free bonds are yielding more than the taxable Treasury securities.
Now, we know without a doubt that the tax code is not going to be repealed. We also know that taxes on incomes falling in the middle and upper income tax brackets in the US have gone up by a large amount. In addition, investors are now subject to the 3.8% ObamaCare tax, on top of other taxes that may be particular to individuals in various jurisdictions.
What is causing this dysfunctional pricing in the market? There are two different sets of investors that determine these bond prices. In the US, about 20 or 25 million Americans determine the price at which they will buy or sell a tax-free municipal bond. They compare it with other investments and make judgments individually. They are the portion of our population that pays higher taxes. The other 90% of Americans ignore tax-free municipal bonds. They do not think about them.
The US Treasury curve and its interest rates, on the other hand, are determined by the entire world. An investor in Singapore or Dubai is attuned to the yields and term structures of US Treasury obligations; however, those investors have usually ignored the US tax-free municipal bond market. That is no longer entirely true. There is evidence that some sophisticated bond buyers outside the US are purchasing tax-free municipal bonds because the raw yield is higher than that of Treasuries. Such investors believe that sooner or later the present dysfunctional pricing will return to a more normal spread.
Logic would suggest that a high-grade tax-free bond should yield less than a taxable Treasury bond. It usually has in the past and is likely to do so again in the future. Between now and then we are seizing on this bargain provided to us by market dysfunction.
The bond market sell-off was a rout. It rattled and terrified investors, and the process of healing is still underway. Tax-free municipals in the US high-credit categories are very cheap.
We shall soon assemble in Maine for the annual fishing expedition, discussions, incantations, debates, and wagers at Leen’s Lodge. Bloomberg Television is scheduled to cover the event and broadcast live on Friday, August 3, 2013. Tax-free and taxable bonds, Federal Reserve policy outlook, and markets will be among the intensely reviewed topics. We will have more to report along the way.
David R. Kotok, Chairman and Chief Investment Officer