The irrational fear of muni bond defaults

All the negative news has created a massive buying opportunity

Dec 24, 2013 @ 12:01 am

By Roberto Roffo

This year has been full of an exhausting parade of headlines related to defaults and potential defaults in the municipal market. While some of these headlines are warranted because of the size of the default, very few municipal bond managers were surprised by Detroit or the problems Puerto Rico is having.

The bigger surprise came as credit spreads widened to levels typically associated with defaulted bonds for an issuer that is still investment grade. Add a few smaller issuers that defaulted to the headlines and it may seem that Meredith Whitney's prediction has come to fruition. While her prediction is far from accurate, in our opinion, the fear mongering has played an important part in creating an environment of irrational fear among investors.

A deeper look into the history of defaults reveals some very surprising facts that are overlooked when investors are worried about which one of their holdings is going to default next out of the thousands of issuers in the municipal market. According to the most recent study of defaults done by Bank of America, year-to-date defaults through Nov. 26 are at $2.47 billion versus $3.81 billion for all of 2012.

According to those numbers, the municipal market would need a 54% increase in its current total in the last month of the year just to match last year's defaults. Add on top of that fact that $2.47 billion is only 0.08% of the $3 trillion municipal market. Break the numbers down a little and only include investment grade securities, according to a study done by BNY Mellon, the worst default rate they could for find is 0.30% and that is for BBB bonds after 10 years. Compare this default rate to similarly rated corporate bonds over the same timeframe at 4.74% and the fear seems unjustified.

(See also: 8 financial predictions that flopped )

This irrational fear has had investors running to the exits for most of the year as the market is witnessing historic outflows. The outflows have caused forced liquidations by managers at levels they might not have sold bonds at, which has led to municipal bonds trading at significantly cheaper levels relative to all other taxable fixed income asset classes. Municipal bonds have historically traded at 85% of U.S. Treasuries, due to the fear generated by the overabundance of headlines they have fluctuated at 100% of Treasuries.

When the numbers are looked at rationally and investors realize the risk associated with the municipal market, they will realize that all this negative news has created a massive buying opportunity, whether they believe rates are headed higher or not. The relative cheapness of municipals and the steepness of the yield curve can provide a cushion if rates do rise in the future. One thing to keep in mind is that the municipal market is not an easy place to navigate and a professional money manager is imperative in structuring a portfolio that will take full advantage of the cheapness of the market, and to monitor the credit of the portfolio in order to avoid the risks that do exist.

Roberto Roffo is senior vice president/portfolio manager at Advisors Asset Management.

0
Comments

What do you think?

View comments

Recommended for you

Featured video

Events

Why blockchain matters to financial advisers

Lex Sokolin, a futurist and entrepreneur focused on the next generation of financial services, explains why every financial adviser should pay attention to blockchain and so-called cryptocurrencies.

Latest news & opinion

Nontraded REITs to post worst sales since 2002

The industry is on track to raise just $4.4 billion, well off the $19.6 billion it raised just four years ago, as new regulations hinder sales.

Broker protocol for recruiting a boon for clients

New research finds advisers whose firms have joined the agreement take better care of customers.

Meet our 2017 Women to Watch

Introducing 20 female financial advisers and industry executives who are distinguished leaders, advancing the business of providing advice through their creativity and hard work.

Raymond James executives call on industry to keep broker protocol

Also ask firms to pay for the administration of the protocol to 'ensure its longevity and relevance.'

Senate committee approves tax plan but full passage not assured

Several Republican senators expressed reservations about the bill, and the GOP cannot afford too many defections.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print