DWS: Munis attractive even - or especially - if taxes rise; Stockton, Detroit not typical

By Paul Deckelman

New York, April 20 - Taxes are expected to shoot up at the end of this year, assuming the Bush tax cuts are not extended again and the various new taxes layered into President Obama's health care overhaul kick in.

But all of that negative noise should have little or no adverse impact on the municipal bond market.

On top of that, despite the much-publicized money woes of some local governments, such as beleaguered Detroit and Stockton, Calif., more municipalities seem to be finally getting their act together and getting their spending and pension obligations under control. Some are making progress.

That's the view at DWS Investments, Deutsche Bank's U.S. retail wealth-management unit, which sees the bonds of states, localities and other public agencies - already largely tax-exempt - becoming even more attractive should taxes on everything else rise.

Philip G Condon, a managing director who heads up DWS' municipal bond department, said that in years past he received a lot of questions from clients about the possibility that munis might lose their vaunted exemption from most federal, state and local taxes as governments scrambled for revenue - considered an unlikely prospect.

But lately, he said, "It's more about why are munis still cheap if all of these taxes are going to increase at the end of the year?"

The answer to that, he said, is "maybe the market doesn't appreciate that yet."

Higher taxes a boon for munis?

Condon, who runs a muni portfolio and also is the overall chief fixed-income strategist at DWS, told reporters at the company's regular quarterly outlook briefing that the worst case scenarios include a proposed hike in taxes on dividends from 15% currently to as much as 40% under the so-called "Buffett Rule" and a 3.8% tax on highest earners contained in the health care law with the top personal income tax rate going up to 39.6%, as well as a projected government spending cuts and fund sequestrations.

But if the worst case scenario does come to pass, he said, "It would not be the end of the world."

"I don't think that's going to happen. But if that worst-case did happen, it would be very attractive for one asset class - munis," Condon said.

"A slowdown in the economy would probably also be good for Treasuries, if [their yields] can go any lower - but since munis have the tax exemption, all other alternatives would be taxed at a higher rate."

Condon does not think that investors at this point are putting money into munis because of that. "But it's one of those scenarios that is out there and starting to be talked about as a possibility," he said.

"To me, if you can buy munis at 100-plus percent of Treasuries in the highest asset classes or 100-plus percent of corporates in single-A, you should buy right now. But if the scenario is that the tax is going higher and the economy slowing down, it makes our asset class even stronger," Condon said.

Issuer woes not a deal-killer

One factor that has put some investors off munis in recent years, though by no means all, are dire predictions that state, county and municipal governments face major problems down the line from past excessive growth of public spending, particularly entitlements and labor costs.

On top of that, slowing local economies in some places have caused the loss of businesses, jobs and residents, and with them - tax revenues.

In some cases, extreme problems have called for extreme solutions. The city of Central Falls, R.I. filed for Chapter 9 protection last August after failing to win concessions from its public-employee unions. That was followed in November by Jefferson County in Alabama, which also sought protection from the holders of $4.2 billion of debt - the biggest municipal bankruptcy in U.S. history.

And in February, Stockton, in central California, warned that it might default on certain obligations. It voted to suspend debt payments and agreed to enter a mediation process aimed at heading off possible bankruptcy under the provisions of a recently enacted California state law that gives municipalities in financial distress an opportunity for financial restructuring.

If those talks fail, Stockton, with a population of about 292,000, stands to become the largest U.S. city to seek Chapter 9 protection.

But Condon asserted during his presentation that cases like that of Stockton, or of blighted Detroit, are the exception in municipal finance, rather than the rule. He called such situations "outliers."

"You will always have Stocktons and Detroits - there are always stories like that out there," Condon said.

In fact, he said he is surprised there aren't more of these problems given the way states and localities gave out generous contracts to municipal unions when times were good.

"In good years, it's pretty easy to negotiate a good contract. If you have a bubble economy like Stockton had, with housing doing so well, it's 'let's share the wealth,' " he said.

Before housing cratered during the 2007 subprime mortgage collapse, average local home prices swooned by 44% from September 2006 to September 2007.

In good economic times, municipal governments give generous packages. "Then when it crashes, you have to work through this problem," Condon said.

He said investors who buy their muni bonds through a fund, such as the ones DWS maintains, have the advantage over those lone-wolf investors who do their own homework when it comes to localities heading for a problem.

"If you bought your own bonds, you might not know that [something] is a troubled credit, on its way down. But in a diversified portfolio with research, we could avoid those problems," he said.

But overall, he said, "The credit story is improving, that is, that revenues continue to improve."

He said that while a lot of states and municipalities piled on too many obligations when things were going good, the pension problems and the employee health care problems are pretty universal.

"From my point of view, it's enjoyable watching how each municipality is slowly trying to fix these problems. It's too slow, but it's going in the right direction," Condon said.

Long-term single-As are sweet

Condon said that DWS is currently buying "long single-A cushion bonds at over 4%. That's pretty attractive."

He called such bonds, "The sweet spot for us."

"If you look at the historic volatility and the structure of those bonds, I would compare those to 10-year Treasuries. And if I can get 4%-plus, tax-free, on a similar volatility and asset class - with more credit risk, yes," he acknowledged, " versus 2% in Treasuries, I think it's a pretty good case."

He noted, "That's the pre-tax case. The after-tax case is obviously stronger."

One issue he said he likes is California state general obligation bonds. "Despite the headlines sometimes, [it] is a single-A state [security] at 4%, with a bond that trades to a 10-year call, at a high premium," Condon said.

He noted that its volatility is only about 60% that of a comparable Treasury security. "And at a very attractive yield, that's a good place to be," he said.

On the other hand, he doesn't see much value in the shorter end of the curve. He said there's not a lot of juice in that part of the curve, particularly for retail investors, to buy something under five years that they really can't sell just to earn 1% more than comparable Treasuries, or less.

DWS likes the single-A bonds, even though that kind of a rating "requires a little more credit work."

Retail investors, he said, "get a little nervous when they see an A-rated bond, even though there's very little default risk to that category."

But he's confident that "we can provide a little extra homework and get better value there."

Munis still cheap

Condon said that at this point, municipal bonds are still cheap versus where they probably should be, all other things being equal.

The muni market saw a selloff throughout much of last year, which was reflected by sizable outflows from municipal bond funds. But of late, he said, "The flows continue to be good, the performance is good."

While he said that muni prices haven't been as cheap as they were last year, during the selloff, those levels "were ridiculously cheap - now they're just cheap."

"I think the investors are starting to get that," Condon said.

Condon said he wonders at what point the investor overweighted in bonds versus stocks would turn. But, he said this is not the usual market cycle.

For one thing, there is continued volatility in equities and a slow-growth environment.

"They don't seem to be leaving the muni market at all," he said.

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