Munis Take a Hit

The municipal bond market is a conglomeration of general obligation and revenue bonds that are issued to fund things like sewage and water treatment plants, hospitals, rural development projects, and general government operations. It used to be known more for its quiescence than anything else, but not any more. The credit crisis has sent waves of change and uncertainty through the municipal bond market.

With 35 years of experience in “munis,” Raye Kanzenbach, a senior portfolio manager at Voyageur Asset Management, a Minneapolis firm offering equity and fixed-income investment services, has one of the longest perspectives on the current situation of anyone in these parts.

In June, at the time of this writing, municipal bonds had been cheap relative to taxable bonds for a few months. They are less liquid than some other bonds, and because a major part of the financial crisis has been a matter of liquidity, these bonds remained somewhat protected from the market’s ups and downs. Now, investors have concerns about the declining credit quality of bond insurers; many have just stopped buying bonds while assessing the situation.

Has the market settled down more recently?

RK Yes. Municipal yields have been stable over the last few months while the yields on U.S. Treasury and other taxable bonds have risen (meaning their prices have gone down). Now the relationship between the taxables and tax-exempt bonds is more or less at a normal level.

Are we headed for another situation where municipal bonds are again out of line in terms of a historical price relationship with Treasuries?

RK Right now, they’re still relatively cheap to Treasuries, but every kind of bond is cheap to Treasuries, which is another way of saying Treasuries are very rich because of the flight to quality in times of uncertainty. Whether we are in a recession or near a recession, it’s hard to know. The employment numbers have become quite weak, but it’s hard to tell whether investors are going to rush back into Treasuries—driving up prices, which would lower yields. That would reverse the trend of the last couple of months.

If, all of a sudden, the economy gets very weak and you aren’t generating tax receipts for municipals, does that affect those bonds?

RK It could a little bit. But remember, the great majority of municipal bonds are not general-obligation bonds, [which are repaid through various tax sources]. Most of them are revenue bonds, [which are supported by revenues from a specific project]. In fact, in weaker times there is a greater demand for general-obligation bonds than revenue bonds, because revenue bonds are perceived as somewhat riskier. General- obligation bonds may do better than revenue bonds, even though they may come under some budget stress. In a recession, the biggest risk for most general-obligation bonds might be a downgrade of one credit rating notch, which isn’t a big deal.