- Volatile ratings leave retail investors at risk.
- Retail investors could pay higher prices.
- Deck is stacked against retail investors.
With an increasing focus on the benefits of owning municipal bonds — attractive after-tax yields, low historical default rates and relatively low volatility — investors are again considering purchasing individual muni bonds. But the deck may be stacked against the retail investor. The allure of owning individual bonds is found in the set interest payment schedule, the defined maturity date and the knowledge that, assuming the bond does not default, it will mature at par. While these may be valid reasons to choose an individual security over a mutual fund, the environment for purchasing individual bonds has become much less friendly for retail investors. The combination of reduced supply, credit uncertainty, rating agency volatility and a pricing structure that favors large institutional investors has put the retail investor at a disadvantage.
Supply — Anemic new issue supply leaves investors starved for bonds to purchase
Many investors have been frustrated looking for bonds that meet their criteria. The muni market has been in a period of negative net supply for several years, with the amount of maturities and bond calls exceeding new issue supply. A review of recent supply data (Exhibit 1) reveals how severe this shortage has been: borrowing for new money (non-refinancing debt) has been approximately $50 billion below the long-term 10-year average issuance of such bonds. In spite of designated retail order periods, institutional investors who purchase large blocks of bonds continue to receive the largest allotments of new deals. With the ongoing shortage of bond supply from the primary market, investors are looking to previously issued bonds available in the secondary market. However, here too retail investors are at risk as more frequent public rating downgrades cause prices to decline.
Exhibit 1: Tax-exempt bond issuance, redemption and net supply (2012-2013 YTD)
Source: Goldman Sachs, December 27, 2013
Ratings — Stale and often volatile ratings leave individual investors at risk
Individual investors typically rely on the rating agencies to determine the credit quality of securities they are considering for purchase. Unfortunately, these ratings, especially for secondary market purchases, are often stale. In addition, the ratings may be volatile due to agency rating recalibrations as well as changes in rating criteria. Since the demise of the bond insurers and subsequent spike in the number of uninsured bonds, analysts at rating agencies are now required to follow a larger numbers of issuers. This increased workload comes at a time when many state and local governments are still addressing the lingering effects of the recession as well the ramifications of depleted pension funding. These factors have been exacerbated by the ratings recalibration, a large scale rating adjustment that resulted in sweeping credit upgrades. In 2010, Moody’s and Fitch moved thousands of ratings higher based on a recalibration to the corporate rating scale. They mechanically moved these ratings — without reviewing the underlying credit fundamentals. As these issuers have come to market, or had their credit ratings finally reviewed, the result has often been multi-notch downgrades — often referred to as “super downgrades” — as the recession left them worse off than before the recalibration. For example, the rating of City of North Las Vegas was increased from A1 to Aa2 in conjunction with the 2010 rating recalibration. Subsequently, the rating fell to A1 in June 2011, to A2 in August 2011, to A3 in March 2012, to Baa2 in August 2012, to Ba1 (junk status) in July 2013 and, ultimately, to Ba3 in January 2014 (Exhibit 2). Drastic rating moves such as in this example leave investors with wide price swings, along with anxiety about the likelihood of ultimate repayment.
Beyond rating activity related to the recalibrations, the agencies have been actively changing their ratings criteria, placing more or less emphasis on various credit factors, e.g. pensions, economy and finances. These changes have given rise to a very confusing dynamic regarding upgrades and downgrades. Last year, the three major agencies moved ratings in vastly different directions (Exhibit 3).
Exhibit 3: When rating agencies disagree
Sources: Standard & Poor’s, Moody’s and Fitch Ratings
Such actions have likely caused confusion among many individual investors who rightly wonder which, if any, agency to trust. This confusion is perhaps best exemplified by the Town of Stratford, CT which saw its general obligation rating raised by Standard & Poor’s and lowered by Moody’s — on the same day!
Worse yet for the individual investor, mutual funds and other institutional investors with dedicated credit research teams are constantly identifying and selling bonds with potential credit problems prior to rating agency downgrades. These securities are typically sold to unsuspecting retail investors who only become aware of the credit problems after the bonds are downgraded, which frequently results in negative price movement. Truly, the retail municipal bond buyer faces a daunting task when it comes to evaluating credit and competing against the significant resources of institutional asset managers.
Pricing — Over-the-counter market leaves individual investors at risk of paying higher prices
The municipal market is an over-the-counter market, without a centralized clearing process, where individual buyers and sellers agree on prices for specific transactions. In this environment, institutional investors, such as mutual funds, have access to real time pricing information from the dealer community beyond the delayed pricing feeds available on regulatory websites. However, pricing information for individual investors is typically not readily available or is difficult to evaluate, based upon the thousands of trades on bonds of varying coupons, maturities, call dates and ratings. In this environment, individual investors cannot really know if they are getting a good, or even fair, price on the securities they are buying or selling. While the difference in price paid for the same bond on the same day by a mutual fund and individual investor may be small, the aggregate of these small discrepancies over time may result in materially lower returns — both in price and yield — for the retail investor.
Mutual fund solution — Deck stacked against retail buyers of individual municipal bonds
Between low supply, uncertainty related to the reliability and timeliness of credit ratings, institutional competitors and an opaque pricing environment, retail investors face an uphill battle when considering purchasing individual municipal securities. Mutual funds, through their sizeable purchasing power, experienced portfolio management teams, large credit research staffs and dedicated trading desks, provide ready access to a diversified portfolio at relatively low cost, something very difficult for retail investors to replicate. Many fund families offer a wide variety of muni funds — short, intermediate, long, state-specific, national, investment grade and high yield — that accommodate investors’ varying risk tolerances and investment needs. In this era of higher tax rates, the case for owning municipal bonds cannot be ignored. Investors seeking tax-exempt income may be best served by diversified municipal bond mutual funds to help avoid the risks and costs associated with owning individual bonds.
There are risks associated with an investment in a municipal bond fund, including credit risk, interest rate risk, prepayment and extension risk, and geographic concentration risk. See the Fund’s prospectus for information on these and other risks associated with the Fund. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.
Income from tax-exempt funds may be subject to state and local taxes and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal and state income tax rules will apply to any capital gain distributions and any gains or losses on sales.
Diversification does not ensure a profit or guarantee against a loss.
Credit ratings typically range from AAA (highest) to D (lowest), and are subject to change.