Municipal Bonds Look Attractive Relative to Other Bonds

By Gus Krafve

January 6th, 2011

The municipal bond market is $2.8 trillion in aggregate and is comprised of over 60,000 different issuers. These issuers vary by location, maturity, interest rate, revenue sources, etc. Even within one state, there can be high performing municipalities and under-performing municipalities. Certain state and local issuers are in more obvious trouble than others, but this observation cannot be used to make blanket statements about the vast and highly diverse municipal market as a whole. In fact, investment grade muni bonds have proven to be among the safest bonds in the world, with a default rate of only 0.16%. This rate compares to a default rate on investment grade corporate bonds of 4.04%.

Within the different structures of muni issues at Trust Company of the Ozarks, we focus on general obligation bonds and revenue bonds tied to essential services. Revenue bond holders are generally protected by rate covenants, additional bonds tests and debt service reserve funds. Essential service bonds are supported by dedicated revenue streams from projects like water, sewer, public power or transportation. Essential service enterprises can usually raise rates with less political resistance than governments that must raise taxes. A general obligation bond is backed by a government’s full faith, credit and the taxing power of the issuer. The courts have respected that pledge in the past by requiring issuers to raise taxes in order to meet these obligations. In many states, debt servicing is mandated to be given priority over any other obligation, which means debt service comes before paying for education, pensions, salaries, transportation, and entitlement programs.

The performance of municipal bonds has softened over the last few quarters due to the well publicized budget shortfalls by some municipalities and the flood of new issuance muni bonds, as many municipalities have rushed to take advantage of certain short-lived government subsidies, such as Build America Bonds, Qualified School Construction Bonds, and Qualified Zone Academy Bonds.

Despite weakness in the overall bond market in the fourth quarter, all major segments of the markets posted positive returns this year. The absolute returns for 2010, for the major market indices, which includes dividends, are as follows:

           S&P 500                                    +15.06%
           Dow Jones Ind. Avg.              +11.02%
          NASDAQ Comp.                      +16.91%
           S&P MidCap                             +26.64%
          S&P SmallCap 600                +26.31%
          EAFE (Foreign Developed)    +4.82%
          Long-term Treasuries            +9.37%
           Barclay’s High Yield Bonds   +15.12%
          Barclay’s Aggregate Bond     +6.54%
          Gold                                            +29.70%
           CRB Commodity Index           +29.96%
          U.S. Dollar Index                      +1.42%