Last week, Warren Buffett said Berkshire Hathaway would be ending insurance on some $8 billion worth of muni bonds, leaving many investors scratching their heads, wondering if Buffett knew something they don’t.
But Van Eck’s senior municipal strategist and portfolio manager Jim Colby recently told IndexUniverse’s Correspondent Cinthia Murphy that Buffett’s exit likely points to the improving health of the muni market rather than to its deterioration. What’s more, he said that when it comes to fears of default given the current capital constraints many municipalities are facing, what a handful of California cities have taught us so far is that when it comes to bankruptcies, contagion is largely overrated.
Van Eck manages more than $1.6 billion in muni ETF assets, half of which are linked to the firm’s Market Vectors High Yield Municipal Index ETF (HYD).
Murphy:The financial crisis is now five years old. Unemployment rates remain somewhat elevated. How impaired is the government’s capacity to raise funds, and how is that affecting the performance of munis?
Colby: Without downplaying any aspects of the recession, we’ve been for quite a ride in municipals as an asset class. We went through two significant downturns:the end of 2008 and end of 2010—the first when the recession was recognized and the latter when there was no evidence of a recovery at a time when [banking analyst] Meredith Whitney came out and warned about defaults in munis, saying they were the beginning of the next wave of the U.S. economic crisis. That fostered an environment of fear and questioned the viability and creditworthiness in the space. What followed were massive outflows from all muni products.
But we finally had a return to sanity by mid-2011, when investors realized that much of what she said wasn’t coming to pass. Consequently, we saw a very strong last quarter for munis in 2011 and a solid first half of 2012. Assets have continued to come back to munis and we are now facing demand that’s outstripping supply, producing strong valuations.
Murphy:So it seems there’s no growing doubt over the government’s ability to raise capital, even as we’ve witnessed a handful of towns already announce plans for or even file for bankruptcy?
Colby: We are going to see downgrades and bankruptcies, and that is the natural order of things in the context of a recession. But on balance, the muni market is a very deep marketplace with a rich history of repayment. Even if in the short term we see a handful of defaults, history has shown that, longer term, solutions can be found to repair and repay. Munis have a better rate of recovery than bonds in the corporate space, approaching rates as high as 70 percent. Investors’ comfort level seems to be more in evidence despite the bumps in the road, and I see little difficulty for most all issuers gaining access to the capital markets right now.
Murphy:How do these city bankruptcies play out? Who is at most risk?
Colby: These cities that have filed for bankruptcy are signaling that they have problems, and there is no minimizing its significance. But it’s also important to remember that we are talking about six or seven cities out of 60,000 issuers in the muni marketplace. Their problems are local, and each city can identify where and what the discrete issues are, so the industry is not faced with a contagion concern.
The problems like badly negotiated union contracts or badly projected revenues are specific and localized. If we were going to see a domino effect from these bankruptcies, we would have already seen hundreds of towns go through it. What it really highlights is the importance of thoughtful credit analysis, which is what you get with professional management.
Having said that, there’s no doubt that states will fare better, and large cities will fare better than smaller cities, which will in turn fare better than municipalities. The trickle-down theory of federal transfer payments applies here and would suggest that those at the bottom will get fewer dollars from those resources. These smaller issuers will definitely be at higher risk at least until the economy in general begins to recover.
Murphy:Last week, Buffett said he planned to end insurance on more than $8 billion in munis. Is that a sign of perceived increased risks in the space?
Colby: That’s a great question. Warren Buffett entered the muni marketplace to create and insure muni bonds when other main insurers fell by the wayside at the height of the crisis. Buffett came in and filled a niche and need by insuring bonds when there was a lot of uncertainty in the marketplace. But now confidence has emerged, which has narrowed profit margins for insurers like Buffett. I think he is leaving because margins might have gotten too small to justify his expenses.
Murphy:Do you attach any significance to his exit?
Colby: I think it reflects the return of generally stronger, healthier issuers. There’s less opportunity, by Buffett’s standards, to make money insuring bonds.
Murphy:I’ve heard that the subsidized nature of Build America Bonds led a lot of longer-term, higher-quality issuers to turn to BABs in the past couple of years, which caused a scarcity of nontaxable munis and ultimately bid prices up artificially, pressuring yields. Do you see this playing out? Is the supply tightness linked to this at all?
Colby: Build America Bonds were enacted after the “crash” in 2008 by the American Recovery and Reinvestment Act as a way to inject cash into the hands of states that could allocate capital to public projects and get people back to work. Nearly $200 Billion of BABs were issued over two years and it was a success. While states put the BAB money to work, fewer tax-free bonds were issued. But it wasn’t until Q4 of 2011 that demand, in the form of extraordinary inflows, overcame supply and produced higher prices and lower yields. BABs had a temporary and positive impact upon municipals, but their impact upon current yield levels for bonds is now minor.
Murphy:How would QE3 affect the balance of things in the muni space?
Colby: Right now, it’s a great time to refinance or to launch new capital projects. The opportunity some of these issuers have now to come to market is significant, because rates are near all-time lows. This opportunity should continue to be the case if the Fed keeps rates at or near current levels. Even though QE3—in whatever form it may come—would not necessarily be applied directly to munis, its design would be to stimulate economic growth and have the impact of continuing to hold the cost of capital at low levels. Any resulting economic growth can only benefit the financials for towns and cities.
Murphy:Despite concerns over possible muni bond defaults as the global economy continues to show signs of slowing down, most muni bond ETFs are still in the money. Are they a viable alternative to low-yielding Treasurys for investors who are looking for fixed-income exposure?
Colby: If an investor wants to make a commitment to fixed income, despite the low income potential right now, municipal bonds is your asset class. The advantages are:(1) very low default rates; (2) broadly diversified products that provide nice exposure while protecting against the decline of a single issuer; and (3) low-cost transactional ease via the NYSE.
Although absolute rates are very low, earning 2 percent or so utilizing munis isn’t bad. You would have to earn more than 3 percent in a taxable equivalent to come out with similar income in your pocket, and you are not going to find that equivalent quality in other fixed income—broadly speaking. Treasurys certainly won’t do that for you, and very few corporate bonds would offer similar yield at the same credit quality, so when it’s all said and done, munis are yielding more than comparable taxable products. As long as the Fed keeps rates low, you can’t afford to keep money in cash and earn zero. In this context, munis make sense.
Murphy:This is an election year, and much has been said about taxes. How would higher tax burdens affect muni bond performance?
Colby :Higher taxes only make munis more valuable and more important. If an investor is being taxed more, buying tax-free income allows an investor to keep more of what she/he earns.
Murphy:Generally speaking, fixed income is still a rather illiquid and more difficult-to-access asset class when you compare it to equities. Have ETFs made a difference?
Colby :ETFs have definitely made it possible, or at least easier, for people to access asset classes such as munis. Not only are they cheaper and more transparent than mutual funds, they dilute the risks that come from holding a single bond and they trade on large exchanges—people find comfort in seeing them openly traded. There’s no obscurity to it.
We [at Van Eck] have five muni products with $1.6 billion under management, and we have seen significant inflows in assets in recent months. I think that’s the case not only because more and more investors are taking advantage of the opportunity that munis offer right now, but I think that ETFs have helped make the distribution of that tax-free income to investors easier and cheaper, so they are catching on.
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