John Ferry
09/01/2005
In the wake of record-setting issuance earlier this year, municipal bond bulls are advising that private investors boost their allocations to munis, which they say have outpaced all other nonalternative asset classes on a tax-adjusted basis for the past several years.
But despite the robust growth of the market and its strong performance, concerns are growing over the health of the monoline insurers that underpin it and the increasingly central role that hedge funds are playing as liquidity providers.
“If you measure their
performance over the last 3-, 5- or 10-year periods, munis have been the
best-performing asset class,” according to Paul Disdier, New York–based director
of municipal securities at Dreyfus, the mutual fund company. He notes that
municipals returned, on average, 4.5 percent last year. “A lot of that came from
the income component, so when you figure that there is also a tax advantage,
that figure is comparable to a taxable bond or a stock that returns close to 8
percent.” Few taxable nonalternative investments came anywhere close to that in
2004.Many investors do not understand this disparity, and assume that munis and comparable taxable bonds perform the same, net of taxes, notes Peter DeGroot, New York–based municipal bond strategist at Lehman Brothers. “In theory they are priced to take account of the tax difference, but in actuality the yield levels available in the municipals market would suggest otherwise,” he says.
Multi or Mono
Despite its strong performance, there are several new
structural concerns weighing on the market. “I think it would be hard to make
the case that we’ll continue to enjoy the returns that we’ve had for some time
now,” says Peter Coffin, president of Breckinridge Capital Advisors, a Boston
firm that manages money for private investors. Specifically, Coffin is worried
about the health of the monoline insurance firms, such as MBIA, Ambac, FGIC and
Financial Security Assurance, that have traditionally insured munis as their
single (mono) line of business. In the past decade they have branched out to
insure securitizations of various types, including increasingly complex
structured credit products such as collateralized debt obligations (CDOs).
“I
would have been more comfortable with the insurers had they stuck to their
traditional lines of business, and all of us are struggling to assess MBIA and
other insurers’ exposures,” Coffin explains. “I think the majority of premiums
that MBIA will write in 2005 are likely to be in asset-backed securities and
CDOs. It is more difficult, because those markets are newer, to assess the
adequacy of the insurer’s capital in relation to the risks they are
taking.”
| Municipal Bonds: Trends at a Glance • Munis have outperformed comparable corporates on a tax-adjusted basis. • Munis have outperformed all nonalternative asset classes for several years. • Muni investors worry that monolines have stretched their capital by underwriting risky structured credit products. • Hedge funds have become crucial long-tenor liquidity providers. • A structured credit crisis could stretch monolines’ capacity to support their muni underwritings. • Rising rates or a tax-status revamp could cause hedge funds to exit the market. |
Hedge funds now play a crucial role in balancing out a demand-and-supply mismatch inherent in the municipal market, Coffin explains. Most municipalities issue longer-term (20- to 30-year) instruments. Retail investors want shorter-term investments. “Hedge funds take a lot of that long-term issuance and flip it around,” Coffin says.
Coffin worries that a significant change in the interest rate environment could cause the hedge funds substantial losses, precipitating their retreat. Similarly, state legislatures and Congress occasionally propose pulling munis’ tax-free status in gambits to balance their budgets. Hedge funds exposed to these interest rate and tax risks could retreat from the market if legislators begin to consider this option seriously. Their absence could cause severe damage to liquidity at the long end of the market.
Capital Ideas
Despite these concerns, most experts point out that the risks of a monoline capital crunch or a wholesale retreat by hedge funds are slim. “There is certainly enough [monoline] capital adequacy,” Disdier says. Should they need more capital capacity, they can arrange secondary lines of reinsurance, he adds. Even MBIA, the monoline with the highest-profile problems right now, retains the market’s confidence. “We haven’t seen any kind of weakening on the bids of MBIA-insured bonds,” notes Jay Abrams, chief municipal credit analyst at investment company FMS Bonds in North Miami Beach. “And in any case, the type of bonds that it tends to insure are those that don’t really need bond insurance.”
Meanwhile, DeGroot believes any drop-off in demand from hedge funds will not be catastrophic. “Some of the slack in demand from hedge funds would be replaced by demand from traditional municipal buyers, who still manage to hold two-thirds of the assets of the tax exempt market,” he says. He adds that investors who believe that interest rates are set to rise may find this a good time to invest in munis. “Municipal securities have a long record of outperformance relative to benchmark taxable issues as rates rise. That should be a big draw for investors,” DeGroot says.