Municipal Bond “Reversion Trade”
The following trading strategy was implemented last month and is for information purposes only. It should not be indicative of the success of future strategies and is for illustrative purposes and the use of sophisticated institutional clients of LOM.
The Story
Municipal bonds are considered the second safest fixed income category following securities issued by the federal government. Within these bonds, general obligation bonds are considered the safest, since they are backed by the full faith, credit and taxing powers of the government that issued the bonds. The bonds usually yield less than US Government Treasuries because interest payments from municipals are exempt from federal income taxes. The average yield on a 10 year general obligation bond is 80% that of a 10 year Treasury bond.
Municipal bonds are proving that the liquidity credit crunch has left no sector untarnished which is now presenting investors with an intriguing opportunity. Municipal bonds are now yielding more than Treasuries. In addition, after the tax benefit, the yield difference is profound.
| New York G.O. | US Treasury | US Treasury (After Tax) |
|---|---|---|---|
| 5 Year Bond | 3.25% | 2.5% | 1.625% |
| 10 Year Bond | 4.25% | 3.6% | 2.34% |
This stunning turnabout in valuations of these bonds stem from 3 main factors:
- The Insurance companies that guarantee many of the municipal bonds have had their own credit worthiness tested… While we understand the trepidation, the bonds we are recommending are that of strong local US Municipalities. The solvency of these states and cities are not a current concern.
- The municipal Action Rate Certificate (“ARC”) market has seen many auctions fail in the past month… Although this does create a concern in this specific market (ARC’s), it should not deter an investment in fixed rate, short to intermediate maturity, municipal bonds.
a. ARC’s have long dated final maturities with coupon rates that are reset based on a participant depended auction. If a holder wants to sell a bond they must elect to do so at a scheduled auction. In the past month, many of these auctions have not had participants. These failures are liquidity based and have nothing to do with the underlying credit worthiness of the municipality rather the fact that accounts that were buyers in the past are reluctant to “get stuck” with the bond until maturity. - Hedge funds have been large sellers of municipal bonds to cover losses created as other strategies have failed. As a result, this has created more sellers than buyers in the municipal market hence it has placed upward pressure on prices.
We feel that all of these issues will be temporary and firmly believe there will be a Reversion to the Mean”. Here are a number of other reasons that the municipal market will normalize:
- Municipal bonds deliver dependable returns, losing money only once in the past 10 years--a 2.1% decline in 1999;
- If a new US president raises taxes, municipal bonds will become even more attractive;
- The municipal market will provide valuable protection to rising treasury rates that will accompany an economic recovery. When the recovery is imminent, interest rates will rise, the credit crunch will subside hence making other asset classes (municipals first) more attractive. When this happens the municipal rates will naturally rise much less than comparable treasuries (if at all).
- On the flip side, if the economy continues to stagnate, the treasury market will eventually become completely unattractive (Short Treasury Bills traded as low as 0.02% on March 19th). As this happens investors will naturally shift to the next safest asset class, municipal bonds.
The Trade
Take this example of a municipal bond yielding 130 percent of a comparable Treasury (i.e. same maturity):
Part 1: Find an Undervalued Bond
A New York, NY General Obligation (Aa3/AA-rated) maturing in August 2013 is offered at a 3.25 percent yield compared with a U.S. Treasury bond of nearly the same duration currently yielding 2.50 percent.
The after-tax return on that Treasury for a US Tax Payer in the 35 percent tax bracket would be 1.625 percent compared with the 3.25 percent New York Bond. The end result is an after tax return that is double that of the Treasury bond.
Part 2: Reversion to the Mean
As the municipal market normalizes, the yields on the bond will once again fall below that of US Treasuries (average = 80% of Treasury). On a conservative basis, if we assume the yields will fall to the equivalent level of the Treasuries, here would be your return assuming the Treasury rates remained as they are.
Buy (March 26, 2008) | Sell (March 26, 2009) |
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