The Muni Herd Redux

The Muni Herd Redux
December 21, 2010
David R. Kotok

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Some emails came in challenging us about last week’s “Herd” commentary. Writers asked for examples of the bargains we described as available in Muniland. “Were these non-rated bonds or junk bonds?” some suggested rhetorically.

The answer is emphatically No!

These are very good-grade credits. The point of our recent piece is that the pricing in Muniland is dysfunctional for a variety of reasons. We have explained why in previous writings. The issue now is to take advantage of this market anomaly by doing the homework. Here are live trade examples.

We were able to buy our clients a block of Nebraska Housing Authority. The actual trade was Nebraska Investment Fin. Auth. Single Family Housing Revenue, CUSIP 63968MEG, 6.05% of 9/1/2041 at par. The bonds are call-protected for ten years and the first call is at par on 9/1/2020. There is a sinking fund structure to retire the issue. The bonds are rated “AAA” by Standard & Poor’s. This is a natural rating on the new scale and is not dependent on any bond insurer. JP Morgan Securities was the underwriter; Wells Fargo Bank is the trustee. The maturity size is $34 million and the total issue was $196 million.

Ok, there it is: a 6%, tax-free, AAA-rated bond. This is an actual trade in a current-coupon bond at par. This is NOT a junk bond. This is NOT a non-rated bond. Meredith W. this bond is NOT likely to default.

Some thoughtful emailers asked us about reinvestment risk. In other words, what are we going to do with the income when the short-term rate is zero? That is a fair question. When you see the answer, the opportunity to take advantage of the market dysfunction gets even better. This is especially true for those who are long-term investors and do not need the current income.

Here is a live trade example of a block of zero-coupon tax-free bonds. This one yielded over 7%. It is a high-grade credit rated A2/AA underlying by Moody’s and AAA-rated by S&P because it is secondarily insured by Aa3-rated bond insurer Assured Guaranty, one of the very few remaining credible Muni insurers. The bond is non-callable and compounds the return until maturity in 2046. Therefore, the investor does not face any reinvestment risk.

It is Metropolitan Pier & Exposition Authority, Illinois dedicated tax revenue bonds CUSIP 592248BD. It has very long duration because it is a zero-coupon. Moreover, in the Muni world today, the longer the duration, the better paid you are as the investor. Think about it this way. I put out $86.46 now and get back $1000 in 35 years. I pay no taxes. My risk is very low. What a lovely gift to a new grandchild. In addition, as a tax-free Muni, it is exempt from the “Kiddie Tax.”

Another point is important to consider. This zero-coupon bond is compounding 7%, which means the value is doubling every 11 years. This is a marketable issue, so a sale before maturity is available if you need to raise cash.

Some say they would avoid this bond because it is in Illinois and that state has unfunded pension problems. That’s true for the state but the pension is not the issue here; this bond is secured by tax revenue. I will extract from the press release. Full details are outlined in the Official Statement; see www.mpea.com .

“The debt will be paid back through tourism-related taxes collected by the MPEA, which includes a 6% tax on auto rentals in Cook County, a 2.5% tax on Chicago hotel rooms, a 1% tax on downtown restaurants, and a departure tax on airport taxi rides. If there is a shortfall in those collections, State sales tax deposits are drawn on to cover the shortfall. The three major rating services reaffirmed their ratings of the credit structure supporting the Authority’s bond issue – Standard & Poor’s Ratings Services at AAA, Fitch Ratings at AA-, and Moody’s Investors Service at A2.”

There you have it. A direct pledge of tax revenues is secondarily enhanced by a shortfall pledge of state sales tax deposits. Lastly, a credible bond insurer is a guarantor if all this fails. Note that the ratings are new scale and post-crisis. In our view these ratings are more credible now than at any time in the last 30 years.

Ok, let’s compare these apples with some oranges. Think about what an investor needs to expect in an annual return in order to match 7% tax-free, when adjusting for personal income taxation and for risk. At the 35% top federal income tax rate, this bond grosses up to a taxable equivalent yield of 10.78%. That is without adding your state’s income tax if you pay one. Is the risk adjusted option of an alternate investment 11%? Or 12%? Or higher?

Let’s look at some alternatives. Remember: no tax on the Muni; there will be income or cap gain taxes on the alternatives.

Compare this 7% Muni with other options for an individual investor. By the bond’s maturity, gold will have to go to $16,000 an ounce to match the after tax return from the bond and that assumes no taxes will be paid on the gold trade profit. Add your estimate of taxes over the next 35 years to get a gross up amount needed for gold to equal the bond. The NASDAQ must reach 30,000 to match the bond; and, you will have to sell at the right time and pay no taxes. If this Muni bond had been available when Jimmy Carter relinquished his presidency to Ronald Reagan, you would have paid for it with the Dow Jones Industrial Average then and you would have the Dow Jones value now. And that would be before taxes are in the Dow comparison equation.

Ok. Let’s go from tax-free to the taxable Muni space. Here again the BABs crunch created massive anomalies. Emotional investors panicked. Skilled ones seized the moment.

We will offer proof with one example in the taxable Muni space. BMO Capital Markets showed us this one (December Outlook). They illustrated the dysfunctional pricing that occurred during the month of November and when the BABs issuance onslaught hit the market as it became likely that the legislation would not be extended beyond December 31, 2010. Remember that BABs spreads impact Muni spreads, so if BABs spreads widened, Munis followed. This added to the dysfunction and therefore made more bargains available to the astute investor.

BMO wrote that the corporate bond “10-yr Detroit Edison (DTE) bonds traded +70bps over the 10-year Treasury.” Around the same time, Missouri Joint Municipal Electric Power (MJMEUC) issued 10-year BABs at +295 to the Treasury. BMO noted that the credit quality by rating is about the same on each of these bonds. They added, “DTE operates in one of the worst credit areas of the country while MJMEUC operations are in an area with greater stability.” Think about it: the BABs issue yielded 225 basis points higher than the corporate bond of the same investment-grade rating.

Dysfunction is not uncommon in the Muni world of bond pricing. Media fear-mongering only makes it worse. When you see dysfunction, you have two choices. One is to declare that something is wrong and therefore the market price is correctly reflecting a risk that the bond buyer does not see. We call this the self-doubt, follow-the-herd syndrome. The other option is to do your research and then determine that a bargain exists and seize it.

At Cumberland, we believe the market is engaged in mispricing because it is consumed by emotional behavior. We believe that the bond market often offers bargains for those who are willing to ferret them out and seize them. The three examples prove it.

Speaking of bargains, let us offer one to our readers.

My friend Chris Whalen wrote an excellent piece about the coming development with FDIC insurance premiums for brokered deposits in banks. Chris is a very thoughtful and smart fellow. He rates banks and has followed the crisis closely.

He gave us permission to post his piece on our website. You may view it here.

The list of banks that are impacted and their ratings may be found here.

We thank Chris Whalen for allowing us to share this with our readers.

Since this commentary was written the Muni market has started to rally. Meredith Whitney’s unsupported assertions on 60 Minutes were not debated on the TV show. Since her appearance bond prices are up and yields are down. We have presented the positive value side here. You did not hear it on 60 Minutes. The 7% zero coupon tax-free bond is now trading higher and currently yields 6.75%. We bought some more yesterday.

All the best for the New Year.

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David R. Kotok, Chairman and Chief Investment Officer