5 Ways We Evaluate Muni Bonds

Posted by The Dopkins Wealth Team | Nov 19, 2015 3:51:06 PM

While there have been few defaults in the municipal market, it’s important to note that not all muni bondsmunicipal-bond-6 are created equal. The market offers many different types of bonds backed by varying legal pledges and revenue sources to repay the debt. The following are some of the qualifications it takes for a muni offering to meet our strict parameters to be considered for purchase.

Rating

We buy only high-quality fixed income. We recommend only bonds rated Aa3/AA- or higher at the time of purchase. This rating is solely based on the issuer’s underlying rating and ability to repay its debts. We do not buy based on a separate bond insurer’s credit rating. There are benefits to buying highly rated bonds. First, nonrated bonds have historically defaulted at much higher frequencies than rated bonds. A Moody’s study covering municipal bonds from 1970 to 2014 found issuers rated Aa and above had a default rate of only 0.01 percent over a 10-year period. Second, the diversification benefit of fixed income tends to decrease as you move from Aaa down to lower ratings. Further, if an issuer’s credit quality begins to deteriorate, there will be far more available research and notification, allowing an investor to consider swapping into a higher-quality position. Rated bonds also tend to have better liquidity if they need to be sold.

Sector

We require that a bond comes from either the general obligation or essential service revenue sector of the municipal market. General obligation bonds are backed by the full faith and credit of the municipality. Essential service bonds include water, sewer, highway and transportation, public college and universities, and electric power revenues. These projects are considered essential services because municipalities cannot afford to default on these programs because they are vital to the community. These sectors have historically had much lower default rates than non-essential revenue projects such as housing and health care. There have been 95 defaults on bonds that Moody’s rated from 1970–2014. Only eight were general obligations. The housing and health care sectors accounted for more than 70 percent of the defaults.

Size

General obligation issuers must have annual revenues of at least $50 million. Larger municipalities typically have more flexibility to maneuver through difficult times or increase revenue. Their sources of revenue may also be more diverse and less concentrated within certain taxpayers. There also is far more information available regarding the finances of larger issuers.

Financial Analysis

The Bloomberg data system allows us to access financial information on municipalities including balance sheets and income statements over multiple years. This allows us to look for trends within a municipality’s finances and answer questions such as: Are revenues increasing? Are expenses under control? How much is the municipality keeping in reserves for unexpected shortfalls? If a municipality’s revenues are shrinking or its expenses seem to be getting out of control, we will bypass these credits even if other buying parameters are met.

Pensions

Going forward, unfunded pension liabilities pose the biggest risk by far to the municipal bond market. Over the past 10–15 years, unfunded pension liabilities have skyrocketed for many states and local municipalities. Some issuers are having difficulty keeping up with the annual required contributions, which are becoming a more significant part of their annual budget. These large payments, which are effectively debt of the municipality, could compete for resources with municipal bondholders. To mitigate this risk, we have chosen to eliminate the purchases of bonds where the unfunded pension liability exceeds 125 percent of the issuer’s general fund revenue.

Summary

Our evidence-based philosophy does not believe in taking unjustified risks with fixed income. We focus on high-credit-quality bonds in the strongest sectors with short- to intermediate-term maturities. A municipal bond will only be considered for purchase after it has met the criteria outlined above.

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Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

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Topics: fixed income, bonds, muni bonds, municpal bonds

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The Dopkins Wealth Team Dopkins Wealth Management (DWM) is an investment advisory and consulting firm that specializes in providing comprehensive wealth management services by incorporating tax planning, business succession planning, wealth preservation, and wealth transfer into our investment strategies and fiduciary-based solutions. Whether it’s an individual, institutional investor, Corporate 401k plan, foundation or endowment, our clients benefit from our use of an investment strategy grounded in academic research that focuses on long-term success. The key to our client’s success is our ability to understand their unique financial goals and needs, and integrate that with their need, ability, and willingness to take risk to formulate a long-term plan for financial security and prosperity. For more information, contact Tom Emmerling at temmerling@dopkins.com.

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