Municipal bonds still popular, despite investment's evolution
Anyone who has lived in Palm Beach for 30-plus years probably remembers J.B. Hanauer, the municipal bond house on Royal Poinciana Way. Back then, muni bonds were hot and rightfully so. They still are today.
Along with providing tax-free income to their bondholders, in the early 1980s finding tax-free yields on high-quality bonds of higher than 10 percent was easy. Plus, municipal bonds -- typically referred to as "munis" -- came with a second and perhaps even more impressive angle: anonymity. Because these bonds were literally delivered to their owners on artfully decorated paper, to collect their interest payments, bondholders had to actually clip -- as in cut off -- the bond's coupons attached and take them to their bank for payment.
To ensure that holders of these debt securities were clipping their coupons in a proper fashion, bond houses often provided investors (both the ladies and gentlemen) with delicate little scissors. Free of charge, of course.
Unfortunately, the days of clipping coupons are long gone. So too are many of the safety-deposit boxes and home safes investors filled with their tax-free bond holdings. Those steel vaults provided muni owners with a quiet way to pass their muni bond wealth on to others. Those days of discretion disappeared when registered bonds replaced those bearing coupons.
Today, registered bonds also are history. Instead, bondholders learn about the fixed-income securities not by opening a box, but by reading the statement their brokerage firm or investment company sends them. Ownership has gone from private to transparent and handled electronically.
"Nobody gets scissors. Nobody is getting registered bonds anymore either," says James A. Klotz, of FMSbonds Inc. "Everything now is book entry."
Klotz and Paul Feinsilver are president and chairman of the board, respectively, of FMSbonds Inc., a municipal bond house. With offices in Boca Raton and North Miami, the two have been in the municipal bond business since the 1970s. I spoke with Klotz about municipal bonds investing earlier this month. But before getting to that interview, let's look at a bit of muni bond history.
The past and today
Over the past three decades, there's been more than delivery and ownership changes made within the world of tax-free municipal bonds. Just as yields have dropped from double- to mid-range single digits, concerns over whether issuers will be able to make timely interest and principal payments have surfaced again. Given current economic circumstances and the relatively recent downgrading of the insurance companies that insured municipal bond offerings, that comes as no surprise to both those who invest in bonds or the firms offering them.
Until a few years ago insurance companies such as AMBAC, MBIA and FGIC were making millions as states, municipalities and counties purchased insurance from them to tack onto their bond issues. Doing so meant a little less yield to the investor, but the bonds received triple-A ratings from the rating agencies. The insurance provided comfort to bondholders who worried that in the event of default -- which rarely happened -- the bondholder would be made whole. But as the companies that insured muni bonds grew larger and wealthier (thanks in part to having to pay out very little in muni bond default claims), they decided to expand their business. Unfortunately, they moved into the securitized mortgage bond insurance business. We all know what happened in that arena.
As a result, the once triple-A rated insurance companies saw their ratings downgraded.
Regarding the default rates of municipal bonds, historically it's been far less than the default rate on corporate bonds -- and far less than you might imagine. A Moody's Investor Service report that examined the cumulative default rate of muni bonds from 1970 to 2006 averaged 0.1 percent for all investment-grade municipal bonds. The default rate for single-A bonds was less than that: 0.03 percent. Or, less than that of a triple-A rated corporate bond.
But that was then. Now we're living through the Great Recession, and states and cities face huge financial challenges. According to a recent SeekingAlpha.com article, 48 states now have sizeable deficits, including Florida. How those deficits will affect the promise of timely interest and principal payments to municipal bondholders, as well as the future regarding the number of new issues being offered into the market, remains to be seen.
During the Great Depression, default rates increased to 7 percent, according to the National Bureau of Economic Research. That figure didn't stick, however, as most of the full-debt obligations on municipal bonds were paid back within a year and a half. The result was a municipal default rate of 0.5 percent.
While the economy contracted by one-third during the Great Depression and unemployment soared to 25 percent, the only state to default on its general obligation debt was Arkansas, according to Payden&Rygel, a global investment management firm. But that debt too paid its investors back, 100 cents on the dollar.
Now, part of my interview with James A. Klotz, president of FMSbonds Inc.:
Q: Tell me more about how the insurance companies that once rated municipal bonds mucked up their business.
A: When municipal bond insurance first came into vogue, AMBAC was the first company to offer it; no one really was very interested in it. Why? Because they were taking a product that didn't really need to be insured and providing insurance coverage for it.
However, after problems with New York City bonds in the mid-1970s, insured bonds then became all the rage.
Insured munis ended up being a win-win for everybody. Because of the insurance, municipalities could borrow cheaper and the individual investor had the confidence of a triple-A insurance company securing the debt.
Nobody had a better business than these monoline insurers like AMBAC or MBIA or FGIC. (A monoline insurer is one that provides its services to only one industry.)
Q: What happened?
A: Sometime around 2006, AMBAC ... decided to get into the mortgage insuring business. That's when many were thinking that housing prices would never go down.
Then, all of a sudden, problems with sub-prime mortgages began to surface, and everybody began to realize that the insurers would be on the hook here too.
What happened to this great bastion of insurers was that they started losing their ratings. As a result, today, AMBAC has a Moody's rating of Caa2, a serious junk bond rating; MBIA changed its name to National Public Finance Guarantee Corp. and is rated Baa1 by Moody's and A by S&P; FGIC is now non-rated and so is ACA.
Q: Is there any insurance company writing municipal bond insurance today?
A: Yes. Assured Guaranty Municipal Corp. They are rated AA3 by Moody's and AAA by S&P. Two years ago, 50 percent of all new issues were insured. Today make it less than 5 percent.
Q: What does that mean for those interested in purchasing bonds today?
A: That they have to look at the underlying credit on a bond.
Bond investors need to remember that they are making a loan. And because of that, the most important thing they can ask is, "How do I get my money back if something goes wrong?"
Will the bond be paid for by a taxing power; is it a revenue bond, a general obligation bond from the state they live in? [The investors] need to know where the money is coming from.
So their first question to the person offering them a bond ought to be, "How do I get my money back?" And the person on the other end of the phone needs to be able to explain that.
If the investor doesn't understand any part of the explanation, they shouldn't buy the bond.
Q: Is there something that those who like owning individual municipal bonds sometimes overlook?
A: Yes, investors are often confused about the incomes their bonds provide. For example, they sometimes see a short-term bond paying 3 percent and a long-term bond paying 5 percent as representing a 2 percent difference in income. The shorter term bond is actually paying 40 percent less in income.
That's why if tax-free income is your goal, buy long bonds. They'll pay you more.
Municipal Bonds 101
Looking for a municipal bond education?
Municipal bonds are big business. According to the Municipal Securities Rulemaking Board, the muni bond market is value at $3 trillion. Last year there were 10.4 million trades resulting in $3.8 trillion in face value traded.
FYI: Muni owners are often self-made millionaires who don't typically sell their bonds and hold on to them.
The following sites can help to keep you abreast of what's happening with the muni world:
- www.msrb.org: For those with a love of figures, the Municipal Securities Rulemaking Board has just released its 2009 Fact Book. Download it at www.msrb.org.
- finra.org: The Financial Industry Regulatory Authority. It's the largest independent regulator of all securities firms in the United States. Created in 2007 and dedicated to investor protection and education, you'll find its municipal bond information at finra.org/Investors/ProtectYourself/InvestorAlerts/Bonds/P118923.
- investinginbonds.com: The Securities Industry and Financial Markets Association. This site offers education and information about all types of bonds, taxable as well as tax-free.
Moving to sites owned and operated by private companies, consider these:
- municipalbonds.com: It offers education and information about municipal bonds from issuers in every state.
- fmsbonds.com: Bond investors will find a wealth of information here. Begin at the Bond Forum and find answers to a host of questions asked by the site's readers. And find educational information on taxable and tax-free municipal bonds, including Build America Bonds, plus review the inventory of this well-established Florida bond house.
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