Navigating the world of municipal securities is more challenging today than ever before. Buying municipal bonds used to be relatively simple: Research and select the issues with the highest after-tax yield, then clip your coupons. But in the post-financial-crisis world, fiscal troubles facing state and local governments have changed municipal bond investing. Historically, municipal bond investors used a “laddered” strategy, focusing more on maturity dates than credit selection or security monitoring. Today, with 50,000 issuers to research, fewer “AAA”-rated bonds and the uncertainty surrounding municipal bond insurers, investors are seeking professional help.

Risk Analysis—Beyond Ratings: The recession has strained the finances of many municipal bond issuers, and the number of bonds with “AAA” credit ratings (within the Barclays Municipal Bond Index^1₎ has fallen from 70 percent in December 2007 to 13 percent by August 2012.² Credit research is now imperative, leaving investors with the daunting task of analyzing the credit quality of a large number of highly diverse municipal issuers.

Bond Insurance—A Changing Market: Bond insurers—the companies that states, cities and local governments often used to help enhance the credit quality of the bonds they issue—came under scrutiny in 2008, and most have been downgraded, or have stopped issuing bond insurance altogether. Prior to the financial crisis, insured bonds accounted for more than half of new muni issuance.³ Now, investor due diligence is crucial.

Supply and Demand: Securities dealers have significantly reduced their municipal bond inventories (by 40 percent since 2007⁴). This reduction could constrain liquidity at times for individual investors. Furthermore, spreads between the price that an individual investor pays (to buy) and receives (to sell) a municipal bond may widen (median spreads have increased almost 10 percent since 2007⁵). Recent studies, however, indicate that professional asset managers can obtain a pricing advantage between .8 percent and 2.5 percent over smaller transactions.⁶

Professional Guidance—A Must in Today’s Market: These are just a few of the dynamics affecting today’s municipal bond market. Those who believe in the underlying value of municipal bonds, now, more than ever, should consider the guidance of a professional asset manager.

¹The Barclays Municipal Bond Index is a broad measure of the municipal bond market with maturities of at least one year. To be included in this index, bonds must have a minimum credit rating of at least Baa and an outstanding par value of at least $3 million and be issued as part of a transaction of at least $50 million. The index includes both zero coupon bonds and bonds subject to the alternative minimum tax; ²Barclays Municipal Credit Research: “Barclays Capital Municipal Bond Index,” August 2012; ³ibid; ⁴Federal Reserve Flow of Funds: September 20, 2012 (Security Brokers and Dealers—p. 88); ⁵Nuveen Asset Management Research: “Trade Execution and Active Management,” February 2012; ⁶United States Government Accountability Office: “Overview of Market Structure, Pricing, and Regulation,” January 17, 2012.
Matthew T. Shafer is a Financial Advisor with the Wealth Management division of Morgan Stanley in Boca Raton, FL. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC, www.sipc.org. Morgan Stanley Financial Advisor(s) have engaged Worth to feature this profile. Matthew T. Shafer may only transact business in states where he is registered or excluded or exempted from registration. www.morganstanleyfa.com/shaferbarberwinkler. Transacting business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where Matthew T. Shafer is not registered or excluded or exempt from registration. The strategies and/or investments referenced may not be suitable for all investors. Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one’s state of residence and, if applicable, local tax-exemption applies if securities are issued within one’s city of residence. The tax-exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability. The market value of fixed income securities may fluctuate, and if the securities are sold prior to maturity, the price you receive may be more or less than the original purchase price or maturity value. Morgan Stanley does not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. You should always consult your own legal or tax advisor for information concerning your individual situation.