DWS: Munis have value, though 'easy money' likely finished; issuer finances could be a concern

By Paul Deckelman

New York, Oct. 29 - Municipal bonds may not produce spectacular absolute numbers in terms of yield and rates of total return - but after figuring in their tax-free status, they can still produce attractive gains for investors, according to the experts at DWS Investments, the U.S. retail asset management arm of German financial giant Deutsche Bank AG.

However, while munis traditionally were considered a sleepy, :buy 'em, hold 'em and forget about 'em" part of many investors' portfolios, those experts counsel that the new reality is that investors have to be savvy and on the ball about what they buy - especially since some local, and even state governments, will be struggling with their finances over the coming years.

Retail investors, said managing director Philip G. Condon, the head of the company's municipal bond portfolio management, have been putting money into the muni sector this year at a brisk pace, as part of a larger renewed interest in the overall bond market.

He told participants at DWS' quarterly outlook presentation and press briefing this week that investors' increased rate of savings "is starting to find its way into the bond market, which shouldn't be surprising, given the volatility of equities and real estate and the lack of any yield out of cash. The same story we talked about three months ago and six months ago is still in place."

4%: not so bad

He said retail-oriented fund flows remain strong, running at a nearly $1 billion weekly pace, and sometimes, "we've had unbroken weeks of flows into these funds. That's a very positive thing for the bond market."

He said that while "the taxable guys are seeing a big part of that flow, munis have also been very attractive," particularly when "we are looking at yields on an inflation and tax-adjusted basis. They may not be big absolute numbers - but I think our investors are comfortable with numbers that sound like 4%."

He asked rhetorically "who would have thought that 4% would get you excited?"

The answer, he said, is that "tax-free 4% is not a bad level when cash is zero, and even though stocks have been going up, it doesn't seem that retail is anxious to get more heavily weighted there."

Condon cautioned that "the easy money, of jumping in earlier in the year when things were cheap and seeing substantial total returns, as we have seen in the bond market, is, at least in munis, probably over."

Investors, he reiterated, should not think "that they're getting into a 4½% yield that's actually going to generate a 12% total return," although such double-digit returns were being seen earlier in the year. Instead, he said, "I think we're settling down to a more rational market."

He added that he tells potential muni investors that "you should have a mindset of thinking that you'll get your coupon over the next several years."

What, me worry?

Condon's colleague, Ashton P. Goodfield, a DWS managing director and senior portfolio manager, told the session that before last year, some investors seemed to have "taken their municipal bond investments for granted. They thought the municipal bond market is kind of a sleepy market, and you earn fixed income, and you earn tax-exempt interest and you really don't have to worry about it" - if they could just ladder their portfolios or buy the highest yielding muni bond fund, "why worry?"

Fast forward to 2008, when, Goodfield said, "a lot of investors learned a lesson -- that there are differences in the way that municipal bonds and bond funds can result in total return. There can be wide dispersions of total return," with some muni funds down as much as 50% last year - "the widest dispersions we've seen in a long time."

That, she said, "woke people up to say 'I really need to know what it is that I'm buying'" - the highest-yield fund may not necessarily be the best place for an investor who is looking for "the sleep-at-night type of fixed-income investment that [an investor would think] munis are supposed to provide."

While in the past, at least 50% of all new municipal issues were routinely rated AAA, because the big monoline insurers like MBIA and Ambac had such sterling ratings, that's not the case any more. Goodfield noted that now, only about 10% of the market is coming as insured, and "there are so many more AA, single-A and BBB rated bonds that previously would have been rated AAA. So the market has become even more complex and really requires a focus on fundamental credit quality," with thorough analysis with regard to credit, coupon, call structure and the like.

Goodfield suggested the possibility that "a lot of this money that [Condon] talked about, that's coming into municipal bond funds, is from individuals that ordinarily would have bought their own muni bonds-and are realizing that there really is research required and some opportunity to be gained from active management. I think that's one reason why we're seeing record flows into the bond funds right now, and appropriately so."

She further noted the impact of the ongoing economic downturn on the finances of municipal issuers, who are caught between the proverbial rock and the hard place - while their costs are up, as they are asked to provide more services, such as Medicaid, revenues from various forms of taxation are down.

"While a lot of us have seen positive signs of the recession abating and the economy recovering, there is typically a lag in state budget and local government budgets when a recession has happened. And so we see continued problems in municipalities and their budgetary problems."

The 'elephant in the room'

Condon noted that "the big elephant in the room" when it comes to potential trouble for municipalities - whether a city or county government, a special purpose entity like a school or sanitation district, or a state government - is the impact that pension costs and the other obligations such as healthcare for both current and retired public employees, and in some cases, their dependents, will have on governmental bottom lines going forward. "It's a bigger number than debt service for many municipalities."

Governments have a hard time reining in such costs, he said, because when it comes to negotiating with well-organized public employee unions on desired contractual changes aimed at saving money, "unions are there forever. The politicians come and they go. How hard do you want to fight this month's budget problem - because the guy you're competing against has been there for 20 years - he's not going to retire for 10 more years."

Such was the situation in the San Francisco Bay-area community of Vallejo, Calif. - which last year filed for bankruptcy, the largest California city ever to do so.

"What's interesting about this case," he said, "is they were particularly generous with their different unions because their competing towns were generous. The competing towns could afford it, they couldn't. It finally got to the point where it was crimping their budget," forcing Vallejo into bankruptcy. The city government is asking the courts to set aside costly contractual mandates, over the objections of municipal labor unions.

"It could be one of these cases you want to watch because other municipalities may find that this is one way to solve the problem," Condon said. With a negotiating process that's "almost stacked in favor of the unions, that's why this remedy could be interesting to see, if it becomes common."

Another situation currently roiling the world of municipal finance is that of Jefferson County, Ala., where that state's largest city, Birmingham, is located. With $3.2 billion in outstanding water and sewer district debt, it's "a substantial case that everyone is watching - but it's a good example of how bad you have to be to end up in that situation. Everything went wrong in that case," Condon said, including the big bite which Jefferson's variable-rate securities and auction-rate securities put in the municipal treasury when their rates skyrocketed last year, and even serious corruption allegations against key officials. "It's like a [TV] mini-series," he quipped, quickly adding "we don't own any of their bonds," which have currently stopped trading in the market.

Exceptions to the rule

But while the Jefferson case has made for some juicy headlines, Goodfield told Prospect News in a follow-up interview that it was a sort of perfect storm scenario - "everything that could go wrong with them, went wrong, but it shouldn't be thought of as an example of what's likely to happen."

However tight their budgets, most municipal issuers are in nowhere near the trouble of a Jefferson County or a Vallejo, and Goodfield said that the historically low default rate for municipal securities - under 1% -- will likely "stay very low."

She said that while "there could be some isolated events, I'm not as worried about defaults as I am pressure from downgrades" on the prices of securities, especially since the major ratings agencies "have already shown a propensity to do that; Moody's put the sector - local states and counties - on negative outlook, several months ago, reflecting what we're talking about - the pressures that local municipalities face."

Goodfield, though, asserted that "while that creates risk for an investor, for people who are in the market every day, like us, it creates opportunities for us to find the best-yielding bonds, and to manage our portfolio with all of this in mind."

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