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If you are looking for a roadmap of how credit issues may unravel in the bond markets, I believe the oil and gas industry provides a very instructive model. Two years ago any talk of excessive leverage in that industry was dismissed as near ridiculous.

Blessed Are Municipals

April 11th, 2016 by Kurt L. Smith
  • Rare is my newsletter with good things to say.  How about “it is good to be an investor in municipal bonds!”  As I wrote several months back, municipals were one of the top performing sectors last year.  Now we are going to discover how long the ride may be.

    I am not recanting my position that Bonds peaked in price (bottomed in yield) way back in 2012.  I stand by my position.  But after a quick swoon in 2013, municipal bond prices have been rising and have remained quite firm (low volatility) as they have made their way back towards the highs of 2012.

    Low volatility and rising prices…in this market!?  This is certainly a recipe for those not familiar with municipal bonds to get acquainted.  Municipals appear to be a bright spot, not only in the fixed income markets, but in investing in general.

    A market like this should be attracting funds and according to Lipper FMI municipal funds recently experienced their 24th consecutive week of net inflows.  Investors love higher (and higher) prices on their investments and municipal bonds are no exception.

    While all the added interest in municipal bonds should be a constraint on our finding worthwhile bonds, I feel our scratching and clawing continues to work for us.  From my vantage point, it appears that new money is being put to work in new issues and also further out the curve in longer maturities.  This is nothing new; this is why we continue to focus on the secondary market to find the worthwhile bonds we love.

    To me, the municipal bond market action appears to not only be late in the upward price cycle but also possibly in a manic phase, if there could be such a thing in the staid world of municipals.  Late stage, perhaps manic…does this ring any bells out there?  Sound familiar or similar to other asset classes over the past several years?

    The great news is how we have been able to navigate the low yield (high price) environment for bonds in general as well as deal with the dramatically lower trading volumes the sector has experienced over the past several years.  Historically most trading is done in the new issue market and predominantly for the first thirty days.  Since this is an area we tend to avoid, the fact that trading volumes are but a fraction of what they were in 2008 should not necessarily have a huge effect on us.  Nonetheless, low volume begets low volume and I do look forward to an end of this trend and I believe we should have more and better opportunities down the road.

    Things are already changing in the world of municipal bonds however.  You are familiar with municipal bankruptcies, namely Detroit, and whatever they call the mess in Puerto Rico.  Thank goodness Puerto Rico can’t file for bankruptcy!  Ha!  These are examples of municipalities being over leveraged as they used more debt in an attempt to fix something that was not working.  Unfortunately Detroit and Puerto Rico don’t have a monopoly on being over-leveraged in the municipal bond market.

    If you are looking for a roadmap of how credit issues may unravel in the bond markets, I believe the oil and gas industry provides a very instructive model.  Two years ago any talk of excessive leverage in that industry was dismissed as near ridiculous.  If you could borrow money at low prices and earn double-digit-plus returns, there was seemingly no such thing as over-leveraged.  That was merely business as usual.

    Unfortunately there has been very little business as usual since the financial crisis.  Suddenly assumptions change (what, the price of oil can actually go down…that far?) and an entire industry is suddenly over-leveraged with many companies in, or on the verge or, bankruptcy.

    Usually bankruptcies have a common theme: too much debt.  Since every issuer in the Bond markets has debt (by definition), it is incumbent upon us to be vigilant as to what constitutes too much debt.

    As we saw with Oil and Gas, the too much debt line can shift quickly and severely.  We also know large issuers then to have a large amount of debt outstanding (by definition) and it is nice that we, unlike the largest asset managers in the world, have the ability and freedom to ignore such issuers or the question of whether their debt is too much debt.  No Puerto Rico, no state of Illinois, no Chicago schools, no state of Louisiana, no problem.

    The beauty of the municipal bond market for me is that there are literally tens of thousands of different issuers, terms and conditions.  Large asset managers want/need large pieces, which again, by definition, usually come from large issuers.  This is where much of the municipal market news and talk is centered around.  We, on the other hand, focus on opportunities that we believe to be worthwhile.  We don’t seek issues we think or feel might work out (Puerto Rico may eventually be worthwhile), but instead we seek items that have collateral or a very low amount of debt.

    Municipal bonds continue to be on quite a roll, but like all rolls (particularly after thirty years), this one will end.  The talk about municipals will go from glowing to dour and if other markets are our guide, I expect this change to occur suddenly.  Please remember, not all (actually not any) municipal bond is alike and we have been selecting your municipal bonds not on the basis that the thirty-plus year trend in bonds will continue, but rather the end will occur and it probably will be abrupt.  In the meantime, enjoy the good news, let your friends know you’ve been investing in municipals for years and rest comfortably knowing that you are betting the current trend must continue.

    Burleson Independent School District, Texas Refunding

    Moody Aaa (Aa3 Under), Fitch AAA (AA- Under)

    Permanent School Fund Guaranteed

    Due 8/1 Dated 4/1/16 Maturity: 8/1/2040

    Sale Amount: $120,720,000

    0 2016 2.00% 0.45%
    1 2017 2.00% 0.74%
    2 2018 2.00% 0.89%
    3 2019 2.00% 1.03%
    4 2020 2.00% 1.19%
    5 2021 3.00% 1.36%
    6 2022 3.00% 1.50%
    7 2023 3.00% 1.62%
    8 2024 3.00% 1.75%
    9 2025 5.00% 1.85%
    10 2026 5.00% 1.94%
    11 2027** 3.50% 2.17%
    12 2028** 4.00% 2.32%
    13 2029** 4.00% 2.43%
    14 2030** 4.00% 2.49%
    15 2031** 3.50% 2.72%
    16 2032** 3.50% 2.78%
    17 2033** 4.00% 2.70%
    18 2034** 4.00% 2.75%
    19 2035** 4.00% 2.79%
    20 2036** 4.00% 2.83%
    21 2037** 4.00% 2.88%
    22 2038** 4.00% 2.93%
    23 2039** 4.00% 2.97%
    24 2040** 4.00% 3.01%

      *Yield to Worst (Call or Maturity) **Par Call: 2/1/2026

    Source: Bloomberg

    This is an example of a new issue priced the week of 4/4/16

    Prices, yields and availability subject to change


    The $247 trillion global debt bomb…