Lots of Advisors Still Love Munis

Originally Published on Financial Advisor IQ on June 26th, 2013

Fed, Schmed — Lots of Advisors Still Love Munis

By Chris Latham 

Volatile Treasury prices may be causing headaches around the globe, and public defaults like the one Detroit is stumbling toward might be nauseating local politicians, but neither need stress holders of municipal bonds, according to advisors who specialize in them.

As headlines mount, clients are seeking reassurance that they aren’t overexposed to a suddenly risky asset class long praised as ultra-safe. And many are getting it from their advisors, who are adopting — and telling clients about — strategies for managing the risk.

To be sure, the news is lousy. Muni prices dropped significantly last week as Treasury yields rose in response to remarks by Fed Chairman Ben Bernanke that quantitative easing could begin to slow later this year. Muni indexes tracked by S&P Dow Jones are down 5% to 7% for June, their worst monthly drop since 2008 — worse even than what corporate bond indexes are experiencing.

Meanwhile, last week nine muni deals totaling $2.3 billion were postponed, including one from New York’s Metropolitan Transportation Authority, which cited “market volatility.” On June 24, six more muni deals, worth about $330 million, were reported delayed.

Then there are the underfunded budgets that have recently led some municipalities to waver on loan repayments. Detroit skipped a $40 million payment on an unsecured bond on June 14 and now has the dubious distinction of being the largest U.S. city in history to risk bankruptcy. On June 25, Rhode Island lawmakers debated passing a state budget that allows for defaulting on about $100 million in debt, which would push its future borrowing costs through the roof. Hanging over it all is President Obama’s proposal to cap federal tax exemptions for interest paid on munis, thereby threatening their most attractive trait.

So how are advisors telling the story?

Russell Francis, who has 23 years of experience with investing and tax planning, isn’t about to stop recommending munis to his clients, but he’s managing their fears and expectations. “I had a meeting with clients [Monday] morning and addressed this issue, because they have been hearing about it in the press,” says Francis. His firm, Portland Fixed Income Specialists in Beaverton, Ore., has about $50 million in assets under management.

“To address default risk, I explained how municipalities are actually getting much stronger as revenues increase and debt loads are restructured,” Francis says. “To address market risk, I explained that we buy and hold to maturity, and the losses they see are just paper losses. As for interest rate risk, we ladder their bond maturities to minimize the impact of interest rates.”

Finding Deals

Some advisors see opportunities amid the carnage.

Nathan Kubik’s firm, Carnick & Kubik Personal Financial Advisors in Denver, Colo., keeps about 45% of clients’ assets, on average, in munis, depending on their goals and risk tolerance. He is drafting a note to clients, urging them not to panic and explaining his strategy going forward.

Nathan Kubik

Anticipating a rate rise, the firm, which manages nearly $300 million for 150 families, went on the defensive about nine months ago and bought less-interest-rate-sensitive individual securities. Now, Kubik says, the recent market drop has revealed some bargains. Because he expects rates to rise further, he’s waiting for more market clarity before diving in.

The biggest misperception clients seem to have about munis is that they’re all the same. So Ben Hockema, patiently explains the difference between general-obligation bonds, repaid out of taxes, and revenue bonds, repaid out of potential gains from the projects they fund. The more the project resembles a commercial venture, the riskier it becomes, he says. That means bonds issued by agencies overseeing transportation or water are potentially safer bets than those funding real estate or hospital projects.

“All things being equal, if you can have a source of revenue that is outside the general fund of the municipality, so that the municipality doesn’t have access to that and it’s completely separate, that is what we would prefer,” says Hockema. “Because it’s not going to be affected by the mistakes the people running the city or the county are going to make.”

Other advisors didn’t particularly like munis even before the market rout began and will continue to steer clients away from them. Diane Pearson of Legend Financial Advisors has been unimpressed by the muni market’s low yields for the past few years. The Pittsburgh firm manages about $350 million for 200 clients who tend to hold mutual funds rather than individual bonds. Pearson prefers higher-yielding corporate bonds and bank loan funds. She argues that munis simply can’t match the returns of superior forms of fixed income.

“I cannot justify them,” Pearson says. “There are better alternatives out there.”