What's the Story With Munis?

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What's the Story With Munis?
by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
April 14, 2009

Reprinted from the February 2009 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

If there's one thing investors have learned through all of the economic and market turmoil of the past year and a half, it's that there's something to be said for simple, basic investments—like municipal bonds. They've been around a lot longer than credit default swaps and collateralized debt obligations, and they're a lot easier to understand. But most importantly, muni bonds can offer both relative safety and value in the current economic tempest.

So if you'd prefer to do more with your money than stuff it under your mattress or earn less than 2% on a five-year U.S. Treasury, you may want to consider munis. We believe you can lock in a steady income stream in a relatively low-risk investment, especially if you want to give your portfolio a more conservative allocation.

Spreads reached record levels
In 2008, we saw the downward spiral in credit markets push muni yields to record spreads over Treasuries as hedge funds, banks and bond funds frantically sold munis to meet cash needs. Historically, munis—because of their tax advantages—have traded at yields between 80% and 85% of Treasury bonds with similar maturities.

In the April 2008 edition of this newsletter, we told you that muni yields had jumped from their typical spread to more than 125% of Treasury yields—a great opportunity at the time. Well, in late December, the average yield on an index of five-year, insured AAA muni bonds reached 203% of the equivalent Treasury yield (see chart below). This is unprecedented, because not only is the risk between Treasuries and munis generally thought to be comparable, but munis enjoy a federal tax deduction that Treasuries don't—a real advantage for investors in higher income tax brackets.

The relative benefit of munis compared to Treasuries has narrowed since December as more investors have taken advantage of the opportunities, but many muni yields still exceed Treasuries of equivalent maturities—especially for longer-term bonds. Spreads are also wide because Treasury yields are at record lows, due mainly to the fact that trillions of dollars in investor capital (both in the United States and overseas) have fled to the safety of Treasuries.

Tax-equivalent muni yields

Instrument	Actual yield	28% Tax-equivalent yield	35% Tax-equivalent yield
Five-year AAA insured	2.3%	3.7%	4.1%
10-year AAA insured	4.4%	6.9%	7.8%
30-year AAA insured	4.9%	7.8%	8.8%

After-tax yields based on federal tax bracket and 9.3% state (California) tax rate.¹

Effective, after-tax yields on munis—which benefit those in higher tax brackets—are also worth considering. Tax-equivalent yields for longer maturities have approached, and in some cases reached, Schwab's approximate 8% long-term return expectation for large-cap stocks² (see table above).

To achieve the same after-tax return, you'd have to purchase taxable bonds with the tax-equivalent municipal yield—which is possible, but not without a significant increase in risk. On an after-tax basis at higher tax brackets, total returns on munis outperformed any other bond sector—up 6.3% per year overall—during the past five years.

Bond insurers ... relevant or not?
Another reason muni bonds sold off last year was due to troubles with bond insurers—companies that collect premiums to insure muni bonds that many experts argue may not have needed insurance to begin with. After years of carrying AAA credit ratings, most muni insurers had their ratings (and the benefit of their insurance) downgraded due to exposure to subprime loans and derivatives.

Muni bond investors typically value safety, and to many, the seal of approval provided by insurance turned many muni securities into commodities—the bonds available were safe, and essentially all the same. But we believe munis are still largely safe, even without insurance; thorough analysis of the underlying issuers is just more important. Even with a downgraded insurer rating, muni bonds are secured, first, by the underlying government entity issuing the bonds. The insurer steps in only if the issuer cannot pay. For issuers with solid investment-grade ratings, this almost never occurs.

When considering individual bonds, look closely at the ratings based on the underlying issuer—bonds often carry an "enhanced" insured rating along with an underlying issuer rating. In many cases, the latter may actually be higher than the insurer rating, representing a still-strong credit, possibly at a discount price.

Mispriced ... or fundamental risk?
Insurance aside, default rates on municipal credits have historically been very low. Most issuers—especially general obligation (GO) bond issuers—have many protections and guarantees even if they face revenue shortfalls, budget problems or expenditure cuts. GO bond issuers pledge their full faith and credit to bond payments, including full taxing authority, and guarantee that they'll raise taxes to support bonds even at the expense of other obligations.

Revenue bonds are secured by a public service or enterprise, such as a water or sewer utility. For core, essential services, revenues for these types of bonds have generally remained strong. While history isn't a perfect guide for the future, here's some data to consider:

According to a Moody's Investors Service study completed in March 2007, only one Moody's-rated GO or water/sewer obligation bond has defaulted since 1970, and it quickly recovered in full.
When New York City nearly filed for bankruptcy in 1975, it deferred payments on some short-term notes, but did not default on long-term debt—nor did Cleveland in 1978. No other recent bankruptcy (Orange County, Calif. in 1994 or Vallejo, Calif., last year, among others) has led to a default on GO bonds.
Since 1970, 40 rated muni obligations of any kind have defaulted, with an overall cumulative default rate over any 10-year span of 0.29% for investment-grade munis (not including GO and water/sewer bonds), compared to 0.52% for AAA-rated corporate bonds.
During the Depression, defaults did rise—15% of total state and local government debt defaulted between 1929 and 1937, according to a National Bureau of Economic Research study. Actual permanent loss of principal, however, was only 0.5%.

Given these statistics, we believe the current spread between muni bonds and Treasuries should compensate for the relative risk.

Budget crises, credit challenges?
Still, there's no denying that many state and local governments have been struggling. They've been impacted by the dual punch of collapsing revenues—primarily property, sales and income tax collections—along with rising costs. Reports of governmental budget strains are often highly publicized, given the focus on taxpayer dollars, public needs and the role of politics.

We believe pressures will remain, and some governments may fail to pay some obligations—particularly salaries or expenses as well as, possibly, short-term loans. But historically, very few municipalities (especially since the Depression) have defaulted on long-term debt.

Barring catastrophe or a breakdown of political will, muni bondholders enjoy certain guarantees. Municipalities—unlike corporations—have more reliable assets to pay with (such as a permanent tax base) and cannot simply disappear, in our opinion. Also, the recently passed stimulus bill included a sizable component dedicated to supporting state and local governments, but it's by no means a cure-all for municipalities facing sharply falling revenues.

Revenue bonds secured by essential service revenues have historically been considered relatively safe investments, and there are many other muni types as well. Some vary in their sensitivity to changes in revenue or economic conditions.

Spread your eggs around
Whatever your strategy regarding muni bonds, diversification, as always, is the cheapest form of insurance. We suggest at least 10 individual issuers for adequate diversification. While default risk is low, there's still event-driven risk to consider. Diversification across maturities is also important, to cushion against interest-rate changes—right now, muni spreads compared to Treasuries may be wide, but interest rates overall are at historic lows. Despite the loss of tax benefits, consider munis outside your home state as well.

If you don't have the funds to allocate to at least 10 issuers, or the time to manage a portfolio of individual bonds, consider a municipal bond fund. For some suggestions, see Justin Holt's Municipal Bond Funds Take the Spotlight article, or clients can log in to take a look at the Schwab Mutual Fund Select List®.

If you are considering buying individual bonds, make sure you talk with a Schwab Bond Specialist (800-626-4600) about the underlying securities. To learn more, clients can log in for much more about bonds.

Muni Bond Sectors and Types

When you buy individual muni bonds, it's important to fully understand the issuer, the security pledged to bondholders, and risks particular to the type of muni. Security does vary, and there are tens of thousands of individual bonds and bond issuers outstanding. It's especially crucial for bonds carrying lower—or in some cases no—"unenhanced" bond ratings (ratings without considering bond insurance), especially in the BBB/Baa category and below. We generally don't recommend purchasing bonds with no underlying issuer rating.

General obligation bonds: The most common muni bond type and generally considered to be the most secure. Issued by states or smaller entities, including school districts, cities and towns.
Water/sewer revenue bonds: Second to GOs in safety due to the nature of the services they provide, they're generally recession-resistant. Households need water and sewer services, no matter the cost.
Other enterprise bonds: Includes solid waste services, toll roads, airports, mass transportation, bus districts or other services. Can be more volatile, depending on the service provided.
Special tax bonds: Secured by dedicated taxes, like a sales tax or household assessment. Ratings tend to reflect the size and depth of the tax base as well as coverage and legal protections.
Lease-backed bonds: Often called certificates of participation (COPs), these are secured by the pledge of a municipality to make lease payments to a trustee for use of a building or other asset it owns and leases back for its own use. Slightly less secure than GOs.
Nonprofit healthcare bonds: Among the higher-risk muni issuers due to business challenges and competition, these also tend to carry lower ratings.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than their original cost. See Schwab.com for more recent performance.

1. Actual individual federal and state income tax rates may vary.

2. Long-term (defined as 20 years) average expected return for large-cap stocks. Mid-/small-cap and international stocks are estimated to return about 9.8% and 8.3%, respectively. Actual returns will vary from our estimates, especially in any single year. See What Are the Long-Term Market Prospects for Stocks and Bonds? to learn more.

Charles Schwab & Co., Inc. receives remuneration from fund companies for recordkeeping, shareholder services and other administrative services for shares purchased through its Mutual Fund OneSource® service. Schwab also may receive remuneration from transaction fee fund companies for certain administrative services.

When a bond is purchased or sold, Schwab charges a commission, markup or markdown. Individual bonds are subject to the credit risk of the issuer. Changes in interest rates can affect a bond's market value prior to call or maturity. Bonds are subject to credit, interest-rate and inflation risks. In addition, bonds incur ongoing fees and expenses.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Periodic investment plans do not ensure a profit and do not protect against losses in declining markets.

Municipal bonds may be subject to capital gains taxes, and interest income may be subject to alternative minimum tax. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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