October 2019 Letter
It takes a Muni
By the early 1920’s, civic leaders in the San Francisco bay area (being true Californians) began worrying about vehicle traffic flow on the region’s overloaded north/south ferries. An idea gaining momentum was for a span crossing the Golden Gate Strait at the entrance to the San Francisco Bay. Despite well-funded opposition backed by the ferry operators and years of litigation, in 1928 six counties formed the Golden Gate Bridge and Highway District (GGBHD). The GGBHD became the sole entity responsible for designing, financing, and constructing a span over the Golden Gate Strait.
With the country now mired in the Great Depression, financing such an audacious project became its greatest challenge. State and federal funds were already committed to the construction of the San Francisco–Oakland Bay Bridge, so the $35 million (over $500 million today) Golden Gate project had to pay for itself. Planners at the GGBHD proposed offering forty year bonds with a coupon rate of 5% to be repaid by tolls generated on the new bridge, not by additional taxes. At the time, long term U.S. government bonds were yielding approximately 3%-4%. On November 4, 1930, voters in the GGBHD’s six counties went to the polls to weigh in on the bond plan. Needing a two-thirds majority, the bonds passed 3-to-1 with over 145,000 voters in favor. After two more years of litigation the bonds finally came to market in 1932, but first, not without the help of Bank of America. The Golden Gate Bridge opened on May 27, 1937, and the last of the construction bonds were retired in 1971. The GGBHD bonds were an early example of how local leaders were able to tap the financial markets to fund infrastructure projects needed for growth and maintenance. Today, two-thirds of all infrastructure projects in the United States are funded by municipal bonds.
Why Individuals Love Muni’s
The GGBHD construction bonds would be a tiny sliver in today’s $3.8 trillion U.S. municipal bond market. Muni’s, as they’re commonly referred to, are attractive to individual investors for three key reasons; tax advantages, low default rates, and a low correlation with equities.
Generally speaking, interest paid to an individual holder of a muni is exempt from federal taxation and, depending on state law, interest income may also be exempt from state taxation. California residents are among the highest taxed at a combined state and federal level, but have the deepest pool of state and federal tax exempt bonds to invest in with nearly $400 billion of outstanding bonds to pick from. The accompanying table from Barron’s illustrates how the tax advantage works. When comparing a muni bond with a comparable taxable corporate bond, an investor wants to know the tax equivalent yield. That is, what is the rate an investor needs on the corporate bond to produce the same after tax income as a muni. In the example, a California couple with $250,000 of taxable income would have to find a corporate bond yielding 5.78% to equal the tax free income of a 3% California municipal bond.
The second reason individual investors love muni’s is their historically low default rate. Muni’s come in basically two forms, general obligation (GO) and revenue bonds. GO’s are secured by the full faith and credit of the issuer and supported by the issuer’s taxing authority. Revenue bonds, like the GGBHD bonds, are secured by the tolls, fees, etc. generated by the project. Muni’s have credit ratings issued by Moody’s and S&P and chart below shows that over the past nearly fifty years, muni’s rated “A” or higher experienced virtually no defaults. Muni’s are a vital, and if highly rated, cheap source of funding for local governments, so avoiding default and maintaining a high rating is a top priority for local leaders.
The third thing investors love about muni’s is their low correlation with equities. Historically, muni’s, like other non-high yield bonds, have been negatively correlated with the stock market. This negative correlation helps balanced portfolios, allocated to both stocks and municipal bonds, ride through periods of market volatility with gentler swings in overall portfolio valuation.
How We Approach Muni’s
Our approach to muni investing revolves around what we call the four “D’s:”
• Defensive – We remain defensive in our maturity selection. We stay well within a 10-12 year final maturity range. By constructing laddered or barbell portfolios of high quality bonds, we can take advantage of volatility, while ensuring capital preservation and producing predictable income streams.
• Discovery – Discovering fair bond pricing in an over the counter market is important. As municipal bond market participants have evolved to include more mutual funds and banks Bid/Offer spreads have widened. It is important to research prices prior to execution.
• Diligence – Keeping abreast of economic trends and financial stability, both locally as well as nationally helps to stay ahead of potential credit crises. Detroit and Puerto Rico were not overnight situations, but developed over several years. New tax law changes could impact state and local budgets. It will be important to stay on top of these developing situations.
• Diversification – Diversification greatly helps insulate a portfolio from a specific event or unforeseen negative headline tied to a specific credit or security type. A mix of high quality GO and stable revenue bonds often makes the most sense. Regional and geographic diversification can also help mitigate risks to specific areas.
On the last point about diversification, as the chart shows, there are many different infrastructure and service needs confronted by local governments, and each has unique characteristics that make some more attractive than others. So, we don’t diversify by simply spreading investments around equally to all the major categories. We have certain preferences. For instance, we build a core portfolio of very high quality essential service revenue bonds, along with large stable general obligation bonds. We also favor highly reputable Hospital and Higher Education issuers. In both sectors, rather than picking a specific facility, we prefer bonds issued by a broader network or system. Bonds like these can spread risk over multiple locations and larger constituent populations and meet essential needs.
Longer term, credit analysis is critical as municipalities encounter broader challenges ranging from underfunded pension obligations to the adverse effects climate change may have on infrastructure. While defaults remain low within the municipal bond sector, defaults have occurred. It is important to remember that credit deterioration happens over time. It remains essential to continue to monitor your existing holdings and understand the source and the statutory obligation of the repayment.
Current State of the Muni Market
The municipal bond market has enjoyed strong performance through the first nine months of 2019. Reduced supply in new bond issuance nationally (chart below) combined with increased demand arising from the cap on the state and local tax deductions (SALT) have contributed to significant inflows into municipal bonds. As a result of the reduced new issuance and increased demand, municipal bond inventory, particularly for high tax states like California, has been slim. The trifecta of supply scarcity, fewer individual tax deductions and central banks pushing interest rates lower around the world, have made municipal bonds very expensive. These conditions have also made the municipal bond market less efficient, making price discovery a key determinant of total return. As an independent Registered Investment Advisor (RIA), we have the advantage of being able to compare prices from multiple dealers. This helps us buy or sell bonds at the best price.
What You Keep
At the end of the day, the safety and principal preservation along with the net return on bond investments are what’s important to us. We evaluate each individual client’s federal and state tax rate (any state, not just California) and determine on an after tax basis if a municipal bond is the best yield. In some cases a U.S. Treasury security that carries only a state and local tax exemption, or a fully taxable corporate bond may make more sense for the client. Please feel free to contact your portfolio manager for additional information about municipal bond holdings in your portfolio.
We’ll Buy the Bonds
A. P. Giannini was legendary for his dedication to the development of the San Francisco region. The son of Italian immigrants with a blue-collar background, Giannini believed that banks should lend more freely to working-class people, whom he believed to be fiscally responsible. Following the 1906 earthquake that destroyed much of San Francisco, most banks closed up shop, but Giannini, now President of Bank of America, set up a makeshift desk and issued credit "on a handshake and a signature" to families and small businesses in immediate, desperate need.
In 1932, when the Depression had deepened and nobody would buy bonds to fund the bridge's construction, bridge engineer Joseph Strauss asked Giannini for help. Strauss explained his long battle to convince the city’s leaders that the bridge would improve the San Francisco economy, not hurt it. “If Bank of America does not buy these bonds, this bridge will not be built,” Strauss said. “How long will this bridge last?” Giannini asked. Strauss replied, “Forever.” Giannini said, “California needs that bridge. We’ll buy the bonds.”