Marilyn: Musing on Munis

07/23/2004 12:00 am EST


Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

Marilyn Cohen, president of Envision Capital, author of The Bond Bible, and columnist for Forbes magazine, has the remarkable ability to put the highly complex world of bonds into a clear and understandable format. Here, she discusses municipals, safety, and bond insurance.

"Municipal bonds tend to be good investments for high-taxed investors, and these days the supply is ample. For that we can thank profligate legislatures and the cyclical downturn in tax revenues. But out of a misplaced aversion to risk, all too many investors, particularly institutions, are demanding the safety of insured munis. That's where the issuer takes out a policy that will make bond holders whole if there's a default. The insurance is not free. It cuts a slice out of your yield. Do you really want to sacrifice yield just to get insurance on a municipal bond? You might be better off relying on diversification to get safety, as few default anyway.

"In 1991, according to Thompson Financial Securities Data, 30% of all new issues with maturities of 13 months or more were insured. By last year that figure had leapt to 54%. Memories of the Washington Public Power Supply default of the 1980s and the Orange County, California default of the mid-1990s combined with recent recession malaise propelled the rush to insure. This is an overreaction. The historic muni default rate is less than 1%. The defaults invariably are from small, unrated issuers, like parking garage authorities and wind-power developers that you shouldn't be investing in anyway. The chances are very slim that we'll have another WPPS or Orange County debacle, especially since the economy (hence tax revenue) is on the mend.

"Don't get me wrong. I don't think insured bonds are going to go bust. My point simply is that since you always should diversify your investments, avoiding noninsured munis is foolish. The growing investor preference for insured paper is unwarranted. The average insured ten-year muni yields 3.95%, says Municipal Market Data. This yield is independent of the credit quality of the issuer since it's the insurance that gives the bond its credit quality. The rating agencies generally throw an AAA rating on any bond with insurance from a recognizable insurance company, although uninsured bonds (such as from Morris County, NJ) that rate an AAA on their own are considered even safer and yield a tad less. A single-A, ten-year noninsured bond, though, yields 4.20%. A quarter-point increment is not going to make you rich. Still, every little bit helps. And if you have your muni portfolio divided among 20 bonds from different parts of the country and with different income streams backing them (general obligation, hospital, turnpike, etc.), you have diversified away much of the default risk. Nowadays munis, whether from insured bonds or not, have much better after-tax yields than medium-term Treasurys. For someone in the 35% federal bracket the ten-year T note, recently yielding 4.37%, delivers only 2.84% after tax.

"When might I bend my rule that muni bond insurance is not worth the yield give-up? There are three circumstances in which you might prefer insured bonds. One is if you have too little in the market ($1 million or less) to efficiently get diversification. Another is if you prefer revenue bonds. Who's to say the airport you are financing won't be destroyed by a terrorist or fiscal mismanagement? The third involves liquidity. If you might need to cash out before maturity, you will find that it is much easier to unload an insured bond than an uninsured one without taking a bad haircut in the price. If you are looking to get in now, consider two noninsured issues whose price premiums are entirely justified. I recommend Michigan State Hospital Revenue 5s due Nov. 1, 2009 , non-callable and priced at 107 to yield 3.60% to maturity. I also like the New York City General Obligation 5.25s due Aug. 1, 2014 , callable 2013 for a 4.22% yield to worst call and 4.30% yield to maturity, priced at 108."

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