Review of Investing in the High Yield Municipal Market: How to Profit from the Current Municipal Credit Crisis and Earn Attractive Tax-Exempt Interest Income Hardcover by Triet Nguyen

With federal, state, and municipal governments planning to borrow to cover their operational and pension shortfalls, it's always worth thinking about distressed government credits, and Investing in the High Yield Municipal Market: How to Profit from the Current Municipal Credit Crisis and Earn Attractive Tax-Exempt Interest Income is a respectable effort. Some notes:

• "One can make the case that there is not one but two separate tax exempt markets. On the one hand, there is the traditional municipal market with its extremely low default rate, buttressed by strong, time-tested legal protections (at least for now). On the other, there is the tax-exempt high yield market, which is municipal in name only and which displays the much higher risk and default characteristics of private entity or corporate borrowers. [...] As a further observation, most of the problem credits have historically occurred in two broad categories of risk: real estate and health care."
• "[T]he best time to have maximum exposure to high yield is when the economy is coming out of recession and credit spreads are at their widest. As the business cycle gets in full swing and rates start to rise, credit spreads will tend to narrow to a point where higher quality paper becomes a better relative value. At that point [gradually] improve the average quality of the portfolio..."
• "The collapse of the bond insurers in 2008 and 2009 has created a new opportunity for the credit investor: an entire class of formerly insured issues who never obtained a rating on their own. [...] Sorting through the underlying credit quality of these individual issues will surely produce some interesting values..."
• "Revenue bonds might on the surface seem riskier than general obligation bonds because the revenue bondholder faces the risk of project failure and lacks recourse to general municipal receipts... However, changes to the Bankruptcy Code in 1988 established rights of a revenue bondholder in Chapter 9 that are actually more favorable... [General] obligations are subject to negotiation and restructuring under the plan of adjustment..."

You may recall from The Fundamentals of Municipal Bonds that the "innovative" types of municipal bonds - e.g. revenue bonds that pledge revenue, or special financing districts - were developed partly as a way to dodge the voter approval requirement. A way of forcing additional debt on unwilling voters.

I would add that the two separate tax exempt markets may further subdivide. While the category of poor credits used to be ones that were "municipal in name only", we now see municipalities that were captured by public workers that are unable to service their debts. And out of the three sides that need to compromise - taxpayers, former workers, and bondholders - most of the compromise has been coming from bondholders!

So, municipal bonds are a category where lots of money is going to be lost. That is to say, a category currently comprised of a great deal of illusory wealth. 

3/5

Municipal Natural Gas Prepayment Deals

The second largest holding in the NAZ muni ETF is Citigroup Energy I: Salt Verde Prepay. Here's an article from 2008 about municipal natural gas prepayment deals:

A gas prepayment is a contract under which an agreed amount of discounted gas is supplied over a period that can range from 10-30 years. Crucially, the main difference between a typical commercial prepayment transaction and one involving a municipal utility or public agency is that the latter purchase is financed through the issuance of tax-exempt bonds.

"A public agency can issue such bonds and then use the proceeds to prepay for a specified, predetermined stream of natural gas," says Troy Black, managing director of financial products at BP in Houston. "The municipality passes the proceeds of the bond issuance by virtue of prepayment to a prepay supplier, which then has the obligation to deliver a steady stream of gas."

The article has a hilarious quote: "The market interest rate spreads are not currently conducive to meeting some of the economics that people became accustomed to by the middle of 2007"

"Fitch Affirms Banner Health System's (AZ) Rev Bonds at 'AA-'; Outlook Stable" $NAZ

Good to know - this Banner hospital bond is largest holding of the NAZ muni fund:

"STRONG AND CONSISTENT PROFITABILITY: Despite continued revenue pressure from lower volume, Banner has been able to maintain strong and consistent operating results that exceed Fitch's 'AA' category medians. From 2010-2013, Banner has generated operating margins between 5% and 6.1% and operating EBITDA margins between 13.1% and 14.6%, which is well in excess of the respective 'AA' category medians."

Let The Right Munis In

Detroit:

"The bond insurers and other Wall Streeters on the creditors' committee seem to have scant sympathy for the employees, or anybody else in Detroit. Back in June, some 30 of them agreed to take a bus tour with Orr of the city's mean streets. That was until they were asked to sign routine waivers absolving the city of any liability should the visitors suffer any bodily harm during the tour. The trip was canceled when the Wall Streeters backed out en masse."

Pretty amazing that they lent money to a place they are afraid to go to in person.

Review of The Fundamentals of Municipal Bonds, 5th Edition

Speaking of munis recently, The Fundamentals of Municipal Bonds, 5th Edition is a good primer on them. I was interested in seeing the statistics; how the amount and type of outstanding bonds and issuance has varied over time.

One interesting observation in the book,

"The more politically turbulent [darker social mood] times of the late 1960s and early 1970s had the lowest approval rates [of general obligation bond issues]."

Aha! So general obligation muni issuance is a social mood indicator and we can predict that issuance will dry up when mood darkens.

Another broader realization I had was about the myriad types of municipal bonds. General obligation bonds, where the issuer makes a full recourse promise to repay, used to be the only type of municipal bond. The problem for issuers and the underwriters is that these have to be approved by voters.

So, different types of municipal bonds - e.g. revenue bonds that pledge revenue, or special financing districts - were developed partly as a way to dodge the voter approval requirement. A way of forcing additional debt on unwilling voters. Also a way of issuing shaky debt that is not full recourse.

One other thought - it's kind of strange that there is a market for municipal bond insurance. Why does the insurer earn less than the spread over Treasuries, since it is taking all of the credit risk? Why have this middleman in the transaction at all? There are no corporate bond insurers. It's a fascinating puzzle.

I had two theories. One is that municipal bond investors have basically outsourced their due diligence to the bond insurers. Muni bond investors are largely households or mutual funds operated with thin margins, so outsourcing to a firm with comparative advantage in due diligence works.

The other theory is that the insurers are flimflam operations that operate under the theory that municipal defaults are statistically independent when history shows that they are actually highly correlated - which would mean that the risks are uninsurable like mortgage defaults.

This paper [pdf] explores some other theories. A popular academic explanation is "increased liquidity" for insured municipal bonds. But really, that's just my outsourced due diligence theory.

4/5.

PIMCO Tastes Good Like a Cigarette Should

Barron's article on tobacco munis,

"One quirky feature of tobacco munis is that issuers can't seek bankruptcy protection. Investors are entitled to each bond's earmarked MSA payments, whatever they turn out to be. Interest payments could come up short, and principal repayment might be delayed or not made in full. 'The bonds are generally appropriately priced, given cigarette consumption projections. There may be a shortfall, depending on the bond's structure,' says Tom Metzold, co-director of muni investments for Eaton Vance, which owns tobacco munis.

In its most recent semiannual report, managers of the Oppenheimer Rochester National Municipals Fund (ORNAX) wrote that 'carefully researched MSA-backed bonds are fundamentally sound, and...will continue to provide high levels of tax-free income to the long-term benefit of our yield-seeking investors.' The fund has 19% of its $5.6 billion in assets in tobacco munis, its largest sector-weighting. Pimco could be the biggest holder of such munis. The Total Return fund owns 25% of the Buckeye 5.875% issue."

So, PIMCO is a silent partner in all cigarette transactions.

It's amazing how cigarettes have gone out of style in the past ~50 years.

Upcoming Muni Bond Conferences

• National Municipal Bond Summit, March 26-28, 2014, Fontainebleau Miami Beach
• Municipal Distress, Recovery, & Financial Sustainability Symposium, May 1-2, 2014, Hyatt Regency Baltimore
• The Bond Buyer's Financing Municipal Utilities Symposium, May 16-17, Hilton Houston
• SMITH's High Yield Municipal Bond Conference, October 2-3, 2014, Hyatt Regency Greenwich

Relative Value Opportunity in Muni Bonds?

I wrote a couple years ago about the fifty state tax experiment that is taking place right now:

"consider a division of the country into zero income tax states with stingy welfare regimes that productive people flee to, and ultra high income tax (double-digit %) states with crippling regulation that productive people flee from, in the context of Bill Bishop's Big Sort. Which states' muni bonds do you want to own? Which states do you want to own property in? What if a group of these productive states issued a currency?"

Muni bonds would be a good way to implement this bet. A California or New Jersey muni closed end fund yields the same or less than an Arizona or Texas CEF!

Look at these maps: Annual Income Lost/Gained due to Interstate Migration as a Percentage of State Income, 2009 and State Debt Per Capita, Fiscal Year 2009. Also, Annual Income Lost/Gained Due to Interstate Migration, 1999-2009.

MI, NY, NJ, IL, CA are deep in debt and losing productive population to low-tax, low-debt, low-regulation FL, AZ, TX, and southern states.

A correspondent observes,

"Conservative old money goes to munis when retail gets too excited. Sells them at the bottom and buys stocks. Works every time."

The investor base for munis is retail investors in high tax brackets, but many of them sold out last year because of Detroit and Puerto Rico headines, and because the conventional wisdom is that interest rates can only go up. So yields went up and the closed end funds are trading at discounts to NAV.

Meanwhile, there's basically a red/blue state divide on credit quality. The blue "failure states" are losing tax base and population to the pro-market states with natural resources. This is not priced in to the yields at all.

"Scranton: When Your City Needs to Go Bankrupt"

Bloomberg article today:

"Scranton’s officials are resistant. It’s not clear what they’re waiting for. The best sign that Scranton needs to go bankrupt is that the actions that would have to be taken to service its bonds, guarantees, union contracts and pension obligations, such as more than doubling property taxes, are unthinkable.

Scranton’s finances only work with big infusions of money from asset sales, borrowing or outside benefactors -- which is to say, they don’t work. This is exactly the situation for which Chapter 9 bankruptcy exists."

Are we on the verge of a wave of muni defaults? How carefully vetted are the bonds in the California muni ETFs like CMF and CXA? Are the 2% yields worth it?

How likely is it that you will lose money buying California munis at a 2% yield, either through defaults or rising interest rates? The CXA has an average maturity of almost 16 years.

By the way, it mentions in the article that Scranton was "preparing to float $26 million in bonds, partly to cover the gap in the current year’s budget" when it defaulted on the Scranton Parking Authority bonds and lost access to the credit markets.