The deep dish on why Meredith Whitney was dead wrong on municipal bonds

Investors accustomed to the relatively placid waters of the U.S. municipal bond market have encountered unexpectedly large swells in recent months.

Rising interest rates on Treasury bonds and investors’ reaction to dire predictions of defaulting municipalities led to the worst three-month performance for the muni market since 1994 with the Lipper Intermediate Muni Index falling 3.3% in the final quarter of 2010.

Before that drop, retail investors’ expectations for munis had moved dramatically. In search of tax-exempt yield and relative stability, they poured $70.8 billion into muni funds in 2009, followed by an additional $28.8 billion during the first nine months of 2010.

In the 24-week period after November 10, 2010, however, investors yanked roughly $47 billion from U.S. municipal bond mutual funds. The sell-off in munis was accelerated in part by a brazen forecast from noted banking analyst Meredith Whitney. In December of last year, Whitney stated on CBS’s “60 Minutes” there would be 50 to 100 “sizable” municipal bond defaults resulting in “hundreds of billions” of dollars in losses.

Meredith Whitney predicted a level of
municipal bond mayhem for 2011 that
is looking more unlikely by the
minute.

Whitney is the principal of Meredith Whitney Advisory Group LLC, which produces equity research on financial institutions and analysis of the industry’s operating environment. She was formerly a managing director at Oppenheimer & Co. and graduated from Brown University.

Don’t Believe the Hype

Whitney’s comments were panned by most credible economists as reckless—and rightly so. There is virtually zero chance of “hundreds of billions” in municipal defaults in 2011. Nevertheless, many retail investors reacted to her warning by what appeared to be an indiscriminate sell-off of their tax-free bond holdings.

In light of these recent events, we believe that long-term investors would benefit from a refreshed understanding of the characteristics of the tax-free bond market, while carefully weighing the major risks and opportunities in the marketplace. See: Advisor: Muni’s no longer seem the deal they once did, but some deserve a look.

The scope of the muni market

The municipal marketplace is enormous and diverse, with a wide range of issuers and purposes. There are two major classes of municipal bonds: general obligation – or “GO” bonds – which are supported by state or local taxes; and revenue bonds, which are issued by a governmental entity such as a water utility. Revenue bonds comprise more than half of the long-term municipal bond market and are tied to a specific stream of municipal revenues for debt service and principal repayment.

While municipal debt issuance is broad, the top issuers of municipal debt represent a large majority of the overall market. In the U.S., there are 55,000 municipal issues outstanding with a capitalization of approximately $2.9 trillion. Importantly, just 1% of the issuers – approximately 550 issuers – are responsible for nearly two-thirds of the muni market’s dollar value. See: Schwab gives investors seat at the table for new-issue municipal bonds with J.P. Morgan deal.

The retail investor drives what many believe is the key risk in the municipal market – liquidity. The media provides frequent and often unbalanced reporting on state and local government credit quality, leading to dramatic changes in liquidity and the prices of the bonds. A steady hand and a long-term investment approach will come in handy when municipal bonds become unfavorable to the mass affluent.

Debts and deficits

In the near term, the municipal bond market is not facing a catastrophic debt crisis. Indeed, the extent to which states are “overextended” has been mostly a case of hyperbole. The average state debt level totals 7.3% of gross state product, while local debt totals 11% of U.S. GDP. By comparison, several European peripheral countries have debt-to-GDP ratios well above 100%.
Due to historically low interest rates, the servicing of outstanding debt is less of a concern. Munis have benefitted since the 1980s from falling interest rates on debt issued in the U.S. The average yield of muni bonds from 1957 to 2010 was 5.75%. Lower interest rates equal lower interest payments.

Significant cuts in state general fund spending during fiscal years 2009 and 2010 brought state spending to a level that is fully 9% lower since 2007. More than 79% of cities are reducing their workforce, and 69% are canceling or delaying capital projects. More than one-third of municipalities are modifying healthcare benefits for public sector workers.

Tax revenues are highly correlated with U.S. economic activity. Recent positive economic reports support a cautiously optimistic outlook. According to the Department of Commerce, state and local revenues have grown by almost 6% during the past four quarters as the economy recovered. Their take from real estate taxes has risen by more than 7%. Retail sales tax revenue shows a similar trend. Fundamentals are improving gradually from a weak base.

There are reasons for caution, however. A weakening of residential housing prices would continue to weigh on property taxes at the state level. Notably, significant amounts of federal support are likely to drop off in fiscal 2012, which began on July 1, 2011 for 46 states. States will have to pull themselves up by their own bootstraps—a job that they can and will do, given the ugly alternative of default.

Default risk: The Good, the Bad and the Ugly

The Good

Historically, investment-grade municipal bond defaults have been rare. Cumulatively, investment grade munis have had a 10-year default rate of 0.06% from 1970 to 2009, according to Moody’s.

Since July 2009 there have been 284 defaults on municipal bonds. This seems like a lot, until one realizes that past defaults represent $8.9 billion of issuance, or about 0.3% of the $2.9 trillion market, from data compiled from the Fed and Municipal Market Advisors.

Debt service for local governments is generally a low percentage (5% to 10%) of the borrower’s general fund budget. Governments have in the past, and will likely in the future, cut other spending items before not paying debt service, because debt service is a relatively small part of their budgets and the consequences of not paying are so large. The priority to service GO debt is higher than almost all other government liabilities.

Filing Chapter 9 bankruptcy protection for states is unrealistic, as it is a voluntary, lengthy and expensive process due to the conflicting interests of politicians, financial managers, unions, voters, bondholders and a multitude of other creditors.

The Bad

While muni default rates are low compared to those of corporate bonds, credit risk is alive and well. While investors can be led to feel warm and fuzzy by the traditionally minuscule rates of investment grade municipal default, they need to take a forward-looking view of credit risk. While state GO bonds are likely to be safe, defaults cannot be ruled out among smaller local municipalities and lower-quality revenue projects.

Bond giant PIMCO expects a meaningful increase in defaults at the local level as states reduce funding to localities. In certain areas, a double hit of lower property tax revenues and lack of flexibility in reducing expenditures will serve to create ballooning budget deficits.

Further weakness will likely come from those municipalities depending on future funding from federal and state aid, those counting on property tax increases and those with deteriorating demographics. Localities with aging infrastructures that require significant capital improvements may encounter problems. Localities in areas of decreasing population and weak wage growth, like the Rust Belt, will have more difficulty meeting debt obligations.

The Ugly: Unfunded liabilities

Unfunded pension liabilities and other post-employment benefits (chiefly health insurance) have garnered increasing attention—and for good reason. The estimated magnitude of such public liabilities has reached historic proportions.

The cumulative net-present-value of public unfunded liabilities varies from $1 trillion to $3 trillion, depending on the discount rate used. For example, Northwestern University and the University of Chicago recently estimated that state pension plans are underfunded by about $3 trillion, while municipal plans are underfunded by $574 billion. These are massive liabilities when compared to the total amount of tax-supported debt at the state level of approximately $460 billion. Contributing factors to these liabilities include surging government payrolls in the last three years and the severe bear market in stocks that hit bottom in March 2009.

Despite the headlines, many states have well positioned funding ratios. As of October 2010, California (87%), Texas (84%), Florida (87%), and New York (84%) are all in good financial shape. Alternatively, the most underfunded states included Illinois, Connecticut, and New Jersey.

Even with improving tax receipts accompanying a growing economy, liabilities will continue to be a major challenge. The challenge, however, is long term in nature. The issues that will affect retirees in thirty years are not likely to create defaults in the municipal debt market today.

Focus on the benefits

The case for a professionally managed municipal bond portfolio has grown more compelling. The rising tide that lifted all municipal- credit-related boats over the past thirty years has receded. Munis will continue to migrate from a low-risk asset class to a credit- specific asset class.

As the bedrock to a high-net-worth investor’s investment portfolio, we encourage vigilance and a long-term view on municipal bonds. On an after-tax and risk-adjusted basis, investment grade municipal bonds remain an important and strategic asset class to hold.

Munis remain an important part of a high-net-worth investor’s portfolio, even allowing for a changing yield curve. Munis should not be avoided due to fears of higher interest rates. No one can accurately and consistently predict the direction, magnitude and duration of fluctuations in interest rates.

Investors should look past short-term irrational sentiment and volatility to focus on the long-term benefits of municipal debt as an asset class. We do not have a crystal ball for the upcoming months—certainly not for upcoming years. To this end, a professionally managed municipal bond portfolio will continue to remain relevant. An emphasis on due diligence, diversification, high-quality credit and risk controls will remain our focus, regardless of short-term sentiment in the markets.

Martin Walsh is a vice president of Innovest Portfolio Solutions LLC of Denver, Colo.