When Jason Thomas picked up the Sunday edition of The New York Times on Dec. 5, he grimaced at the headline “Mounting Debts by States Stoke Fears of Crisis.”
“My initial reaction was, "Oh, God, I am going to get at least 20 calls on this tomorrow,'” said Mr. Thomas, chief investment officer at Aspiriant LLC, a multifamily office with $7.5 billion in assets.
While he did receive some calls from anxious clients, Mr. Thomas spent the next several days reaching out to clients to talk about how the new municipal market offers opportunities as well as risks.
Keeping clients informed about the state of the municipal bond market seems to be the marching orders for advisers in 2011 as the media begins focusing on the potential for massive defaults. Many of the nation's largest states — California, New York and Illinois — face growing budget pressures as a result of the lagging economy, stoking fears about what could happen if these states no longer can pay their bills.
Financial advisers, particularly in states where wealthy investors have bought muni bonds as a tax shield, now must deal with a muni market in which the perception of looming defaults is coming increasingly closer to reality.
While the majority of advisers, portfolio managers and economists are not convinced that a wave of defaults among states and cities is inevitable, they all agree that the chance of defaults has increased and is likely to hurt the market. A recent segment on “60 Minutes,” for example, featured noted bank analyst Meredith Whitney describing the current municipal financial situation as second only to the housing crisis in severity, and one that will lead to many defaults this year.
“I am not concerned about massive defaults where whole states are just defaulting across the board,” said Paul Jacobs, a certified financial planner for Palisades Hudson Financial Group LLC, which manages more than $1 billion in assets. “I am more concerned about investor overreaction and that there could be a sell-off in bonds that would lead to losses. That could be as bad as an actual default.”
As of Dec. 10, there had been $8.2 billion in muni defaults in a $2.8 trillion market, according to Municipal Market Advisors. This year, there have been only three defaults — all in Wisconsin — in what investors would consider a safe sector because they were backed by a link to taxes, said MMA managing director Matt Fabian. Those defaults were Menasha's steam generator plant project, the village of Warrens' bonds developed for Yogi Bear's Jellystone Park, and Warrens sewer bonds, which serviced that theme park.
“Historically and currently, the default rates are extremely low,” Mr. Fabian said. “To assume there is going to be a systemic collapse is outlandish.”
That's not to say there won't be any defaults in coming months, however, industry experts said. “I do think we will see more, but I don't think it's going to be that California is going to default and fall into the sea,” said Robert Kane, founder of BondView LLC, which operates a website for municipal bond investors.
And given the fact that there is only one company — Assured Guaranty Corp. — still insuring bonds, advisers and portfolio managers have to do more digging than ever into the credit of municipal bond issuers, experts said.
“This is not your father's municipal bond market,” said David Fare, a portfolio manager and director at Western Asset Management Co., a unit of Legg Mason Inc.
As a result, advisers such as Marilyn Cohen, president and chief executive of Envision Capital Management Inc., which oversees $300 million in bonds for individuals, have spent money on implementing systems to make sure they are on top of all the potential issues with various muni issuers. “Since the credit crisis, we spend more time on scrutinizing municipal bonds than we do on corporates,” she said.
One of the challenges for advisers and portfolio managers is that often issuers don't update their financial information annually as required, she said.
“I see new clients coming in with municipal bond portfolios, and some of the issuers haven't updated their financials for two to three years,” she said. “That's obviously not the big states, but still.”
The Securities and Exchange Commission is investigating whether it should regulate municipal bond issuers and force greater disclosure. The market is regulated by the Municipal Securities Rulemaking Board, a self-regulatory organization.
If the SEC takes on that responsibility, it will be good for the market in the long run, experts said.
“If the agency finds problems, it could cause some short-term hiccups, but in the long run, it would be good to have more disclosure,” Mr. Kane said.
Another issue that will affect muni bonds next year is the fact that tax rates aren't going up for the next two years, making munis less attractive, Mr. Fabian said. Municipal bonds usually are exempt from federal taxes as well as state taxes for residents of states where they are issued.
“Rising tax rates have been a major source of outperformance for municipal bonds, and that has been taken away,” he said.
But municipal bonds remain very cheap, even with the new tax rates, Mr. Fare said. “One of the reasons that munis are so cheap is because Treasuries are so high,” he said.
Another factor that will affect the municipal bond market in 2011 is the expiration of the Build America Bonds program, which will result in an increase in the issuance of tax-free bonds. “Prices will come down and that's a good reason for short-term investors to wait to buy tax-free bonds,” Mr. Kane said.
Overall, the more complicated municipal bond market should create opportunities for advisers specializing in bonds, Mr. Fabian said. “The fear of default has broken the municipal market in half between [double-A] and better big-name issuers, and then everything else,” he said. Advisers who resist rushing to the safest investments, but instead find the ones with the best yield will come out ahead, he said.
And finding the best yields is exactly what Mr. Thomas plans to do. After the article in the Times ran, he spent time reaching out to clients and talking about how the new municipal market offers opportunities.
“Headline risk is your friend if you are a disciplined, sophisticated investor,” he said.
E-mail Jessica Toonkel at email@example.com.