"Why Municipal Bonds in a Time of Uncertainty"

A few thoughts from Lebenthal Asset Management about current market conditions.

by Gregory W. Serbe

In our last update to investors, we discussed how change was a natural phenomenon, and how we must adapt to it. We are still in a period of tremendous economic turmoil and upheaval. It is still our opinion that with uncertainty comes possible opportunity. This opportunity may be in returning to the basic fundamentals of investing in the municipal bond market. More specifically, understand the risk you incur and be rewarded appropriately when you take it. The days of generic investing in “munis” are gone.

We are going to look at some of the profound changes in the market over the last two years. The 2.6 trillion dollar municipal bond market has outgrown its quiet roots and stretched far beyond being an unknown investment reserved for the very wealthy or the very sophisticated investor.
Over the last two years, the slowdown in the housing market was fueled by the collapse of subprime mortgages and other lesser quality housing loans. These loans had been dependent upon low cost financing and an ever increasing value of housing prices. As these loans dissolved into foreclosures, municipal bond investors discovered that the very insurers of the safety of their municipal bonds had been significant participants in this unrelated mortgage market. One bond insurer after another lost capital and eventually the rating services dropped their coveted “Aaa” or “AAA” rating. Concurrently, the same Wall Street investment firms that created the packaged mortgage products badly needed to raise fresh capital. The result was that by March of 2008, a major Wall Street firm was forced into a sale of itself, with taxpayers probably absorbing the losses from the transaction. Subsequently, the list of firms either closing, being sold, or drastically changing their business mix, such as abandoning the municipal market, includes some of the most well known banks and brokerages, many with antecedents that stretch back over a century.

The next element in this mix was the fact that these very firms sold derivative municipal securities and were suddenly faced with having to provide liquidity on these long instruments with short “put” or rollover maturities. As the bond insurers, whose capital standing provided the support for these bonds, lost their credit standing, many of these instruments became illiquid. New investors could not be found to purchase the issues that the old holders wanted to redeem. Dealers didn’t have the capital to take back the unwanted securities into inventory, and investors who were planning to be temporary holders found that they were frozen with their holdings. While some of these issues have been converted into long term fixed rate issues, the process has been painfully long, and slow. Additionally, those investors who owned Auction Preferred Shares of closed end bond funds faced a similar dilemma. At the end of the day, the municipal bond market turmoil became a source of commentary for the financial news media. The rating services received substantial criticism for their inability to assess the risk of the mortgage securities, and then for their poor evaluations of the risks to the municipal bond insurance companies that had insured them. Even those investors who invested in municipal hedge funds discovered that there was no safe harbor for the sophisticated investor. With the “flight to quality” of the security of U.S. Treasury Bonds, and the selling pressures on the rest of the bond market, segments within the overall bond market decoupled. Instead of mitigating the risks of investing in one asset class (municipal bonds) by shorting a different but closely related asset class (Treasury securities), the hedging of a long municipal position by a short Treasury position compounded the effects of the municipal sell-off and the Treasury rally. All of this was subject to the harsh light of daily updates in the financial media.

Additionally, the demand side of the equation shifted. Two types of significant investor classes almost completely disappeared. Municipal hedge funds have either pulled back in capital or are no longer functioning. Property and casualty insurance companies, faced with mounting losses, no longer needed the benefit of tax exempt interest and became sellers of their municipal bond portfolio holdings.

In addition to the reduction in demand due to a change in the players, the very quality of the instruments has come under attack. As reported by the Wall Street Journal on January 26, 2009, over the last decade, state and local government outlays have doubled. Now they are facing record shortfalls in tax receipts. Declining property values and homes in foreclosure will lessen ad valorem property tax collections. Lower retail sales lessen sales tax collections. Lower incomes mean less income tax collections. At the same time as cash receipts are down, the need for transfer payments has increased. Unemployment claims and Medicaid claims are up substantially. With the Federal government supporting the financial and automotive industries, naturally state and local governments have requested Washington dollars from the new administration. The best way to state their case is through a groundswell of support generated through the press. Dire predictions of grim future events help create the need for assistance.
Where does that leave the investor? It is our opinion that the market will return to the basics of investing, and that this will provide some unique opportunities. Given all the negatives (loss of bond insurers, loss of “players” in the market on both the underwriting and investing sides, and weakness in municipal budgets to summarize a few points,) there are certainly reasons to be cautious. Those same negatives are also the seeds for future opportunities. Investors no longer can view their portfolio as just “AAA insured.” The actual credit quality of the issuer becomes significant. With the decoupling of the Treasury and municipal bond markets, municipal yields are actually higher than Treasury yields, without considering the tax advantage provided by municipals. For years a long term municipal bond typically yielded between 80% and 90% of what the comparable Treasury bond yielded. Now as this is being written, the best quality municipals offer 150% of the yield of the comparable thirty year maturity Treasury, and other investment grade municipals have yields that are over 2.5% more than their comparable long maturity Treasury Bond. In our opinion, as a result of the concerns about safety and liquidity, spreads between best quality bonds and other investment grade bonds (AA or A rated) have widened out.


We also feel that the maximum tax rate will increase. It is just not clear whether the current tax laws will simply expire in 2010, or be more aggressively increased beforehand. There is a reasonable probability that state taxes will increase as well. Municipal bonds could outperform in that scenario. We also feel that as the market ceases to be dominated by a few underwriters selling generic “insured” municipals, investors will be given an opportunity to purchase bonds where credit and risk are more closely aligned. This should provide for more opportunities to capitalize on market inefficiencies and thus give a greater return from their municipal investments. And that, in our opinion, is why an investor buys municipal bonds.

“My Belief is My Authority. My Assertion is My Proof.”

By James B. Lebenthal,  President Lebenthal Equity Management      

The S&P 500 first closed above 800 in April, 1996.  In the past week it has crossed below 800.  Let's compare today and then.

In the first quarter of 1996, U.S. Gross Domestic Product was $7.6 trillion.

In the third quarter of 2008, the initial estimate for U.S. Gross Domestic Product is $14.4 trillion.

i.e. GDP has increased by 89%.

For the trailing twelve months ended March 31, 1996 operating earnings for the companies in the S&P 500 were $38.45.

For the trailing twelve months ended September 30, 2008 they were $65.22.

i.e. S&P 500 operating profits are up 70%.

At the end of 1995, there were 124,900,000 employed persons.

In the third quarter of 2008, there were 145,517,000 employed persons in the United States.

i.e. There are 20.5 million more working Americans.

The value of the Net Stock of Fixed Assets and Consumer Durable Goods in 1996 was $23.8 trillion.

In 2007 (data only available by calendar year), the value of the same stock was $46.6 trillion.

i.e. The value of the nation's asset base has almost doubled.

         We could go on with a similar list, but the outcome would be the same.  By many metrics our nation is far, far better off than it was the first time the S&P 500 saw its current value.  Also, in no way have we attempted to quantify the improvement in quality-of-life during the last twelve years.  Cars are sturdier, more fuel efficient, safer, and come loaded with standard features that cost extra in the last decade (side airbags, all-wheel drive, and anti-lock brakes anyone?).  Every day brings news of new life-enhancing and life-extending medical procedures.  You can get more computer in a laptop for $700 today than you could have for $5000 back then.  How do you like your new iPhone and iPod?  Remember, these did not exist in 1996.

         Now, current events are certainly quite a bit different now than then.  But think this through.  Yes, unemployment is rising.  It is unlikely to rise so high as to knock 20 million more people out of work.  And profits will probably be down in 2009 vs. 2008, but they would have to go down 40% to match the 1996 level.  Not only is that unlikely to happen, but if it did, it would probably be followed by an impressive bounce back to a normalized profit level closer to 2008 than 1996.  We can't ignore either the massive write-downs caused by irresponsible and excessive financial sector lending.  But the asset base quote above is a "net' number, as in "net of debt".  All those debts being written down were used to build things, residences, office buildings, factories, cars, etc.  Those assets did not go away.  So the impairment of Mortgage-Backed Securities, Collateralized Debt Obligations, Structured Investment Vehicles, and similar ilk, doesn't affect the "net" stock of the nation's asset base.  Yes, almost every financial institution in the US has written down a massive amount of its asset base, but those write-downs are offset by the write-downs of liabilities by owners of the homes, office buildings, car, and so on.  Morally and ethically questionable, but a wash as far as the collective nation's balance sheet goes.

         One thing has changed dramatically in between these two time periods, though.  In 1996, the US stock market was in the midst of a once-in-a-lifetime bull market.  The S&P 500 appreciated over 25% annually in the five years of 1995-2000.  Now, the S&P 500 is mired in the latest leg of bear market that has lasted an entire decade.  Think about the fact that large-cap US stocks have given no return other than meager dividends, in twelve years.  This is not the normal state of affairs and long-term stock investors know this.

         Let's put it a different way.  By the end of the 1990's, we had had 20 years of average annual stock market returns of 17.8%, well above the long-term average of 11.5%.  In the last twelve years we've had returns far, far below the long-term average.  Reversion to the mean works in both directions.  The naysayers in the late 1990's who warned that we were borrowing future gains to be paid back later were right.  Thus, we received a bear market in 2000-2002.  And right, too, are the optimists now who realize that the stock market is setting up for not just a rally, but a secular bull market.  All indicators, from investor sentiment to implied equity risk premia to the growing enthusiasm of long-term perma-bears (hello, Jeremy Grantham), point to it.

         But more than anything, the improvement in our quality of life and the size of our economy, as listed in the opening paragraph, point to this.

         Stay tuned, and don't lose your courage - the human ingredient that is part and parcel of any turnaround and restoration of credit on which our economy depends.

         We welcome your feedback. . . . .

         Respectfully yours,

         James B. Lebenthal