More on Munis, Detroit, Bloomberg, Whitney & Wilson
David R. Kotok
Cumberland Advisors, July 24, 2013
In our recent commentary on municipal bonds and Detroit, we argued in favor of buying the highest-grade AAA tax-free municipal bond It currently yields more than the corresponding taxable US Treasury obligation.
Meredith Whitney, Muni Cassandra emeritus (ae?), weighed in against Munis (FT) and used the Detroit default to say her version of “I told you so.” Bloomberg reported both sides of the argument.
Readers may seek Whitney’s positions and her history of Muni-forecasting on their own. Our position is clear: do the research and buy the bonds that make sense. There are many of them. This is an idiosyncratic market of $3.8 trillion; painting it with a broad brush is a mistake.
We took the position that the default history of the true AAA-rated tax-free municipal bond has the same default history as the US Treasury bond: neither has ever defaulted.
We offer many thanks to Bloomberg and especially Dave Wilson for picking up our story and for featuring a chart showing the upside-down relationship between tax-free Munis and Treasuries. See Bloomberg.com, “Municipals Seen as Cheap After Detroit Filing: Chart of the Day” http://www.bloomberg.com/news/2013-07-23/municipals-seen-as-cheap-after-detroit-filing-chart-of-the-day.html .
When the tax-free AAA bond has a higher yield than the taxable US government bond, it is not priced according to credit risk or the tax code; instead, it is priced by a dysfunctional market. We used the State of Utah and Yale University as examples of issuers of such bonds.
Subsequently, our friends at Strategas Research Partners published a research note on July 22, 2013, articulating a similar concept. The source for their data is Moody’s Investor Service. We are subscribers to Moody’s, utilize Strategas Research, and find both of great value.
The back-up information for our assertions comes from Moody’s. The AAA-rated (by Moody’s) tax-free US municipal bond has a 0.00% default rate one year after issuance, five years after issuance, and ten years after issuance. Historically, the bond has experienced zero defaults. There is no evidence that any true AAA-rated tax-free municipal bond has ever triggered a default in the state and local government debt sector in the US.
Remember, we are referring to the natural rating of the bond. We are not referring to those bonds that were insured by various bond insurers and thus elevated to an AAA rating because of the bond insurance. Bonds that were rated AAA only because of the insurance have defaulted, but the underlying ratings of those insured bonds always fell below AAA. No true AAA credit ever needed bond insurance to sell a new issue.
Readers may want to note that there is a slight default experience in AAA-rated corporate bonds. It is small, but it is there. The fact is that there is a difference between state and local government bonds and corporate bonds of the highest credit quality. In our discussions, we restricted our comments to state and local government bonds; we did NOT address corporate bonds.
The bottom line is that the true AAA tax-free US municipal bond scale now offers bonds at yields that are higher than the corresponding Treasury bond. This is true at maturities throughout the yield curve, from the short end of 2 years to the long end of 30 years and at every stage in between.
We reiterate our conclusion of yesterday. We continue to favor the high-quality tax-free municipal bond. We think such bonds are cheap. We also note that the overall credit mix of state and local government is improving. That happens when the economic recovery progresses.
Joe Kalish of Ned Davis Research notes the improvement. Using year-over-year data he cites that “Total Tax Revenue” is up 5.1% to a new high of $1.421 trillion. Property tax revenue is up 2.6%; Sales taxes up 4.9%; individual income taxes up 10.3%; corporate net income taxes up 1.3% and other taxes up 4.5%. The “other” means motor fuel, tobacco, alcohol, licenses, death and gift taxes, etc.
Our bottom line: high grade, tax-free bonds are really cheap and their credit support is improving. Score one for Munis; score zero for Detroit; score evenhandedness for Bloomberg media in reporting. We will leave the Whitney scoring to our readers.
Let me add a correction regarding another matter. Bloomberg has indicated it will cover the gathering in Maine, but it will not be broadcasting live on Friday, August 2, 2013. There will be ample media coverage of the event by a number of sources. We are not sure if there will be live television coverage. We will keep readers posted of any changes.
David R. Kotok, Chairman and Chief Investment Officer