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IFA > Article Section > IFA's Concerns with Muni Bonds

IFA's Concerns with Muni Bonds

By Jay Franklin
May 17, 2011

Due to their tax-exempt status, many high net worth investors have become convinced that all of their fixed income exposure should be in municipal bonds. At first glance, the math appears compelling. For example, as of 3/31/2011, a 5-year Treasury Bond yields 2.23% and a 5-year AA-rated muni bond yields 2.10%. For someone who is taxed at a 35% marginal rate, the muni bond yield is equivalent to a pre-tax yield of 3.23%, a full 1% higher than the Treasury bond. One might conclude that only a complete fool would buy the Treasury bond, right? Not so fast.

The very first principle of investing is that there is no such thing as return without risk. Given that the muni bond appears to be offering a higher return than the treasury, the first question to be asked is, “What is the risk that is driving the higher expected return?” Since there are two primary risks associated with bonds (term and default) and both bonds have the same term risk, the difference must lie in the default risk. Treasuries essentially have zero default risk while muni bonds have a level of default risk that explains their higher after-tax yields. Not surprisingly, a 5-year A-rated corporate bond (which is taxable) carries almost the same pre-tax yield as the AA-rated muni bond. This implies that the market assesses the same level of default risk on both of them. Of course, there are many other factors that are incorporated into the prices of both corporate and muni bonds. For the latter, one of the more important characteristics is whether the bond is a general obligation of the issuing government or if the bond is paid by revenues from a particular project such as a stadium. All other things being equal, general obligation bonds are usually deemed to be less risky than revenue bonds.

Given all the recent talk about the enormous budgetary pressures faced by state and local governments, it is not surprising that the market would price their debt on the assumption of some level of default risk. Even if the ratings agencies are reluctant to lower their ratings, the market reacts very quickly to negative news and adjusts the prices of the bonds accordingly. Even if defaults were to be averted by a federal bailout, such a bailout would come with many strings attached (such as the removal of tax-exempt status) that the value of the obligations would be diminished. The argument that default risk can be avoided by sticking to “insured” municipal bonds was proven false in the financial crisis of 2008 when the two largest insurers, MBIA and AMBAC, narrowly averted bankruptcy, thanks to the government bailouts. Details may be found here.

It is essential that non-Treasury bond investors understand the nature of default risk. Unlike other investment risks such as term risk for bonds and market risk for stocks, default risk is extremely one-sided. In general, if a bond does not default, the investor simply collects all the coupon payments along with the repayment of principal (i.e., the investor receives his expected return but no higher). In the event of a default, however, the investor suffers what could end up as a severely negative return. For the bond investor who may have a very low risk capacity, defaults can wreak havoc. For corporate bonds, default risk is best mitigated by diversification among issuers and industrial sectors. Nonetheless, it does have a systematic element that cannot be diversified away (in a financial crisis, there could be a large number of defaults across many sectors). Given the negatively skewed nature of default risk, IFA advises investors to only take a minimal amount of default risk, and to take that risk with companies rather than state and local governments.

The other concern that IFA has with muni bonds is how they are traded. In general, muni bonds trade in a very opaque manner among dealers who make markets in them. Individual investors who trade them through their brokers do not fare well. Jason Zweig of the Wall Street Journal (3/26/2011) highlights a recent example. For $600,000 (par value) of NY/NJ Port Authority bonds, a retail investor sold them at $102.50 and the dealer who bought them sold them three hours later to another retail investor for $106.80 (a 4.2% mark-up, or a year’s worth of expected return). Trades cleared at these prices despite the fact that there were outstanding buy offers of $104.43 and $104.75. The original seller was not given access to those bids by his broker, and the subsequent buyer paid well above the fair market value, again courtesy of his broker. Just exactly how the $25,830 in profits was split among the dealer and the brokers will remain a mystery since no disclosure is required on their part. Investors are best served by highly liquid and efficient markets. As of now, such conditions do not exist for retail investors in the muni bond market.

If a high net worth investor feels absolutely compelled to own muni bonds, then the best alternative would be a passively managed fund from a reputable company such as DFA or Vanguard. IFA’s advice is for investors to own their fixed income in tax-qualified accounts where they have no need to purchase municipal bonds.


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