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Municipal Bond Worries

There's been much talk in recent years of a looming fiscal crisis among state and local governments. Prominant industry analysts even predicted widespread municipal bond defaults in the US in 2011. While that turned out not to be the case, there is still a perception by some investors of rising credit risk among municipal bond issues.

So, is the municipal bond market still at risk for widespread default? No one knows—and we are not in the prediction business. But your view probably depends on your economic expectations and familiarity with the municipal bond market. With this in mind, consider these principles:
·        The municipal bond market is large and diverse. The media often report on municipal bond problems as though the market is a single, uniform sector. In reality, the market comprises an estimated $3 trillion in debt, with about 55,000 state and local issuers and approximately 2 million outstanding issues. These bonds are rated across a broad spectrum of credit categories and have different characteristics and structures for paying their obligations. Such complexity does not afford simple observations about the market.
·        Historical default rates are low. Muni bonds have a strong track record of repayment. One reason is that state and local governments are motivated to avoid default since failure to pay affects their ability to raise capital in the future. Another reason is that most issues repay investors from either project revenues or from a general fund backed by the taxing power of the issuer. The chart below shows default rates for municipal and corporate bonds in the US from 1970 to 2008. There have been no defaults in the top-rated investment grade tier (Aaa/AAA). Most defaults are limited to the non-investment grade universe.
Bond Default Rates—Cumulative Percent (1970-2008)

      Of course, these historical default rates may not be so low in the future, especially if fiscal conditions prove worse than in the past. Investors also should consider the potential for local government bankruptcy. Federal bankruptcy law enables local governments to file for Chapter 9, although some states do not permit these filings and provide alternative means for their distressed local governments to adjust debts. As sovereign entities, states cannot file for bankruptcy protection. But some lawmakers are considering ways to enable financially distressed states to seek bankruptcy protection versus requesting a federal bailout. 

·         Municipal bonds are assessed according to actual financials, not models or projections. Some reports have compared the municipal bond market to the subprime mortgage securities market prior to the financial crisis. The circumstances are different in some ways. Municipal bonds are not exotic instruments with complex structures that obscure the underlying credit rating and market value of the assets.  As a result, munis are generally more transparent than the mortgage derivatives that helped spark the financial crisis. Also, state and local issuers are subject to financial disclosure rules, and the information they provide affects the market prices and credit ratings of their bonds.


·         Current market conditions do not imply unusually high risk. The market incorporates information and expectations into prices, including perceived risk, as illustrated by rising bond yields during the financial crisis and in the recent municipal market selloff. However, since the start of the recession in November 2007, average yields for the AAA, AA, and BBB rated municipal securities have fallen. Also, total market volume as measured by total number of trades has been generally flat over the last four-year period. 
Risk Management Issues
Investors should always consider ways to manage risk in their fixed income portfolios. Here are a few guiding principles:
 ·        Hold shorter-term issues. This approach may help reduce volatility while enhancing liquidity. Also, fixed income investors who hold investment grade bonds must consider their exposure to changes in interest rates. Bond prices move in the opposite direction of interest rate changes—and the longer a bond’s maturity, the greater its price change.

·        Stay broadly diversified. Holding many municipal bond issues and avoiding concentration in a particular state, sector, or issue type can help reduce the impact of a few non-performing bonds. If default rates rise, investors with a well-diversified municipal portfolio should be less exposed.

·        Focus on quality and use market pricing to confirm credit ratings. The most creditworthy bonds are those rated AAA or AA, and most of the current problems involve lower-rated bonds. Although ratings are useful, recent   history in the mortgage-backed securities market has shown that a bond may not be rated accurately. A bond that is rated AAA should trade in a similar price range to other bonds with similar characteristics and a comparable rating. 
Portfolio Decisions

Investors can either hold a portfolio of individual municipal bonds or buy shares in a fund. Building a portfolio of individual bonds offers more direct control over maturity, face value, bond type, credit range, and other issue characteristics. This approach may be useful for matching future liabilities and pursuing other investment objectives. But achieving broad diversification with a custom portfolio may prove a challenge, and the portfolio may be less liquid and expensive to trade, and require more attention and oversight than is feasible for an individual.

Investors often favor professional fund management for many reasons, including enhanced diversification at a reasonable cost and those specific to the way the bond market operates. Since bonds are traded through a network of dealers and not a centralized exchange, price discovery may not be easy. Muni bonds also tend to be less liquid than equities since only about 0.7% of the market is traded daily (i.e., only 14,000 out of two million issues). These market realities result in high transaction costs. In fact, research shows municipal bond trades are significantly more expensive than equity trades of equal size.

Municipal bond funds have better access to multiple dealers than most individual investors and have the capacity for large-volume trades, which renders a cost advantage over smaller investors, particularly when trying to achieve higher name counts to increase diversification. Funds offer better liquidity and broader diversification across issue type, maturity, credit quality, and geography, although shareholders do not control the selection of bonds in the portfolio. They also can access daily security prices and know the average credit rating within the portfolio. Equally important, managers should monitor average yields at different maturities, qualities, and regions to gauge the relative riskiness of different issues.

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