January 2009

As financial storms go, this one was nearly perfect.

In a perverse sort of way, that is.

“When the financial crisis struck last year, municipal bonds got hurt along with almost everything else although not as badly as stocks and corporate bonds,” says Arch King, senior product manager at Northern Trust. “Just about everything that could go wrong, did go wrong.”

About the only asset class that didn’t get soaked was Treasury bills and bonds, which benefited from a global stampede to safety.

Amid the near panic that followed the collapse of Lehman Brothers last fall, yields on Treasury bonds tumbled toward 2% while short-term government debt yielded less than zero.

That last point is so startling that it bears repeating: Investors were willing to pay the U.S. government to hold their money.

“Investors were more concerned with the return of their money than the return on their money,” says King. “That’s what happens when fear dominates the decision-making process.”

Liquidity crunch
But emotions alone don’t account for the poor returns last year in municipal bonds, whose tax-free yields soared toward 6% on AAA-rated paper even as inflation tumbled and the Fed slashed interest rates to nearly 0%.

Normally, tax-exempt rates would have fallen more or less in tandem with their taxable counterparts. After all, municipal bonds compete for investor dollars with corporate, agency and Treasury debt. In typical market conditions, taxable yields are higher than tax-exempt yields.

Not this time.

An unusual array of technical and market factors conspired to push Treasury and municipal bond yields in opposite directions.

With the credit storm in full fury, many state and local issuers couldn’t get short-term financing through what’s called the auction-rate securities market. Issuing longer maturity bonds solved the liquidity problem, but the bulge in supply depressed bond prices — and pushed yields higher.

Meanwhile, hedge funds were forced to pay down borrowings while suffering massive redemptions from disgruntled investors. To come up with cash, the funds sold whatever securities were most liquid or had declined the least. In many cases, that meant dumping municipals, which pushed their prices lower — and yields still higher.

The credit downgrades of companies that guarantee municipals also played a role. Monoline insurers like Ambac and MBIA lost their AAA ratings, which effectively increased risk for the holders of bonds they insured. The market compensated by pushing bond prices down even more and tax-exempt yields higher yet.

Return to normalcy
But storms don’t last forever. Not even perfect ones.

Now the question for investors is whether the unusual factors that pushed tax-free yields up may have created an attractive buying opportunity.

King thinks the answer is yes, in part because the liquidity crunch that caused the municipal sector so much pain is easing.

The auction-rate securities market is gradually being resolved, which should reduce the need for issuers to replace short-term financing with new, longer-term bonds. All things being equal, lower supply means higher prices.

And with the annual redemption period for hedge funds having passed, another source of potential supply has moderated.

“Municipal yields became detached from underlying fundamentals because of the credit crisis,” King says. “That creates some interesting opportunities in tax-free bonds as the crisis subsides.”

Gradual improvement
But even though the perfect storm may be winding down on some fronts, it’s too early to put away the umbrella for good.

One concern is interest rates.

As the economy recovers — and yes, it will recover — it’s likely that the Fed will reverse course and start tightening monetary policy. Granted, that could be some time off, but it’s still something that investors need to keep in mind.

And given that the federal government has been printing money hand over fist to revive economic growth, there’s the possibility that inflation could accelerate down the road as well.

In the meantime, however, some economists are more worried about deflation, or falling prices, a condition that might wreak economic havoc but reward bondholders.

Whenever rates start climbing, the Treasury market seems much more vulnerable. In fact, yields on some long-term government debts are actually below the inflation rate. Go figure.

Could Treasuries be in their own bubble?

“When short-term interest rates finally start rising,” King asserts, “it’s very possible that Treasury yields will climb back past municipal yields.”

King thinks that a return to “normal” rate relationships seems likely, but how we get there — whether Treasury rates rise or municipal rates fall — could make a big difference to investors.

Falling municipal yields, of course, would mean increasing prices, in addition to income generated by the bonds.

Default worries
Perhaps a greater concern to tax-free bondholders should be the impact of the recession on government revenues. Though investment-grade municipal bonds have a strong credit history — its less than 1% long-term default rate is much better, for instance, than the corporate sector — state and local governments nonetheless face hard times.

The recession will take a deep bite out of income, sales and property taxes, the three main sources of municipal funding.

“That’s a legitimate concern,” King says. “Local governments are struggling through the toughest economic environment in many decades, and it’s likely to get worse before it gets better.”

Still, King cautions against painting all municipal debt with the same broad recessionary brush.

Details matter
Unlike Treasury bonds, municipals are not a generic category. Many bonds backed by a municipality’s full taxing power — a category known as general obligation bonds — remain solid credits. So do certain revenue bonds, like those issued by “essential” public works facilities, such as water, sewer or electric power.

“There’s an important difference between a revenue bond that finances a power plant and one that paid for an airport,” King says. “People will keep using essential services, but if an airline pulls out, the airport facility might not be able to make its interest payments.”

Even in cases where a bond’s debt service is backed by an essential service, it’s still important to pore over the fine print.

King says that fund managers need to take a hard look at the terms to make sure the debt coverage has a large margin of safety. When it comes to picking bonds, the devil is in the details.

Importantly, Northern Trust has never used credit-agency ratings or bond insurance as substitutes for diligent in-house research.

“We do our own credit homework,” King says. “Our job is to lend our clients’ money to municipal borrowers, and we take that responsibility very seriously. Northern has a strong credit culture. It’s part of our corporate DNA, and it’s helped us generate solid long-term performance.”

Don’t try this at home
Though municipal bonds seem broadly attractive, King says that investors would be well served to consider buying them through mutual funds, rather than exclusively owning individual issues.

Besides the importance of properly evaluating the creditworthiness of a bond, there’s the not-so-small matter of trading costs. That’s because the difference between the bid and ask price on a bond can often be several percentage points, thus wiping out most or all of the yield advantage over taxable securities.

Because of their size and multiple broker-dealer relationships, however, mutual fund managers are better positioned to gain favorable trade executions.

There’s also the issue of diversification.

As was made painfully clear during last year’s financial meltdown, individual securities can be treated rudely when investors are disappointed or markets change. So it’s always a good idea to spread risk as widely as possible.

Northern’s national municipal bond funds typically hold more than 100 securities. Few investors could gain that degree of diversification on their own. For more information on Northern’s array of tax-free funds, check out “All the Colors of the Rainbow” at the bottom of this page.

Favorable trends
Looking ahead, King thinks that demographic trends and tax-policy changes could further boost demand for tax-exempt bonds. That would be good for municipal bond investors.

As baby boomers retire, it’s likely they’ll convert some of their stockholdings to bonds to generate income, especially since many Americans haven’t saved enough for their golden years. And with taxes all but certain to rise after the economy recovers — especially for upper-income Americans — the tax-exempt status of municipals could become even more valuable.

Which is saying a lot.

When AAA-rated municipal bonds yield more than 4%, the equivalent is nearly a 6% yield in a taxable security for investors in the 28% tax bracket. Though the credit risk is somewhat different, the trade-off certainly warrants some careful thought.

“Historically, municipal bonds yield around 80% of Treasuries,” notes King. “Recently, we’ve been at 100% to 200% of Treasuries.”

Indeed, last December yields on some AAA-rated general obligation municipal bonds were quoted at twice the yield as their Treasury counterparts, even before taxes. That makes them attractive even to investors who don’t pay taxes.

“The math is very compelling in favor of municipal bonds,” King says. “I suspect a few years from now investors might look back at these numbers and wonder why they didn’t jump at the tax-free sector more aggressively. But at the time, it’s hard to see the opportunity clearly.”

Especially in a perfect storm.