MUNIS – GREEN PASTURES OR RED HERRINGS?

By Larry M. Wood – SVP, Financial Institutions Group

Municipal bonds as an asset class have definitely represented green pastures for public investment portfolios over the years. High yields, combined with strong cash flows, low default risks and adequate liquidity, have made munis a market worthy of allocation dollars in public investment portfolios. Going forward, this should continue to be the case, particularly for those portfolios that have a longer duration objective or utilize a barbelled management approach, where the longer end of the portfolio’s barbell is heavily weighted with munis. For a significant number of investors, munis have been a primary contributor to outperformance, particularly when combined with a strong credit review program designed to catch problems before they enter the portfolio, such as in the pre-purchase review, or before they become widely known, such as when they are found during detailed ongoing monitoring of the portfolio as part of diligent oversight efforts.

Outside the credit scare of a couple years past, broadcast by well-known Wall Street portfolio manager Meredith Whitney, who proclaimed there were billions in losses from municipal bonds on the near-term horizon, the muni market is typically a quiet, $3.7 trillion total market selection of issuers ranging from cities, towns, counties and states to myriad special-purpose entities. Most of these have taxing authority and are designed to provide financing for anything from airports, hospitals and higher education entities to water control or fire protection districts, and many other purposes in between.

High yields and low default rates are the typical lure for muni investors seeking safe returns, but the market’s deep-rooted structural issues can turn opportunity into a case where the investment seas can quickly get rough. Efforts can be taken to prevent green pastures from becoming a school of red herring in disguise. Analysis work designed to navigate market disclosure issues are an absolute must in order to generate and protect returns. Municipal structural issues such as non-standardized financial disclosure and the frequent use of accounting formats other than GAAP are only half the problem. The other half includes gaping holes in continuing disclosure (which make obtaining timely information a persistent issue), the absence of third-party independent audits and annual financials, and a lack of regulatory teeth needed to penalize issuers that don’t live up to investor expectations. These two halves combine to create a framework that allows credit problems to lurk just beneath the surface, like an underwater mine waiting to attach to an unprepared muni investor.

Fortunately, though, investors who are prepared to deal with disclosure issues can navigate the rough seas and firmly claim green pastures. Implementing a consistent series of pre-purchase analyses directed at evaluating an issuer’s capacity to pay, extent of leverage use, budgetary soundness and tax revenue stability, as well as evaluating the local/regional demographics and economy, will help ensure that bonds added to the portfolio will perform as expected. Pre-purchase reviews should also include efforts to stay at the top of the security waterfall, such as restricting investment to unlimited tax general obligation bonds or essential-service revenue bonds. Restricting investment to these bond types ensures seniority treatment in the event of credit problems. Assessing historical disclosure efforts, NRSRO ratings reports, financial trends, pension obligations and bankruptcy law eligibility rounds out pre-purchase analysis efforts. Monitoring these items annually, along with material-event notices coming through the “EMMA” muni market repository, will assist in identifying portfolio credit problems before they become too unwieldy.

Municipal market investors must circumnavigate the structural issues of consistently poor financial disclosure to ensure that returns stay in the green. Instituting a program of buying only muni issuers that use GAAP accounting, use independent, third-party auditors and have a proven track record of providing investors with timely and consistent annual disclosure will prove beneficial in protecting your portfolio. Cash-basis, fund-balance or non-GAAP regulatory accounting practices simply do not give investors the information they need. It’s an issue found only in the municipal market, but it’s one that can be avoided with proper screening techniques. Investing in issues that don’t adhere to these disclosure standards could prove disastrous if credit issues arise, because investors won’t have timely, detailed or standardized information to evaluate. Focusing on issuers that have achieved certificates of achievement for excellence in financial reporting by the Government Finance Officers Association will help in these efforts.

Investors expect to participate in markets where supply and demand imbalances provide the basis for investment opportunity and risks can be controlled by access to timely, detailed information. Unfortunately, while those continue to be characteristics of most other developed securities markets, they are not true of today’s municipal bond market. But, where there’s risk (in this case, disclosure risk), there’s reward, and efforts to avoid or manage disclosure risk can keep you in the green. For those muni investors unable to take advantage of disclosure-related imbalances, legislative changes are sorely needed. Current laws lack the teeth needed to force change.

Because of a growing muni investor backlash toward disclosure, the muni market’s regulators, including the SEC and the MSRB, have recently focused long-overdue efforts on closing the disclosure gap, with the intent of bringing muni disclosure in line with that of the corporate market, for example, and with an eye toward protecting investors. The SEC’s current disclosure amnesty program (called the Municipal Continuing Disclosure Cooperative, or MCDC), in which issuers self-report disclosure failures over the past five years, provides an opportunity for them to clear the slate. After September 10, 2014, however, disclosure failures will be deemed fraudulent and there will be no limit in terms of penalties and fines.

Before beginning or continuing to invest in the muni market, public investment officers must understand not only the rewards that typically come from consistent investment in munis, but also that an inability to properly evaluate the credit risks—at purchase or throughout the life of the security—and financial disclosure issues specific to the muni market can leave unprepared investors awash in a sea of red, when they were expecting historically green pastures.

About the Author

Larry Wood has 25+ years of investment management experience in fixed income securities, having managed an $11B state pension fund and a $4.5B super-regional bank portfolio. Larry has a Finance & Banking degree and an MBA, is a Certified Treasury Professional (CTP), is a member of the National Federation of Municipal Analysts and works as a Registered Investment Representative for KeyState Advisory, LLC, an investment management subsidiary of The KeyState Companies, offering portfolio management services for investors throughout the United State. KeyState is NOT a broker-dealer.