INVESTING IN MUNICIPAL BONDS: How to Balance Risk and Reward for Success in Today's Bond Market - Rilegato

FISCHER

Rilegato

ISBN 10: 0071809759 ISBN 13: 9780071809757

Casa editrice: McGraw Hill, 2012

Riassunto

Strike the perfect balance between risk and reward to maximize profits

Investing in Municipal Bonds provides an overview of the bond market and describes the “personalities” and traits of various types of bonds—along with the strategies you need to draw greater profits than ever. The book gives you expert insight into:

• Municipal securities
• Variable rate demand obligations
• Portfolio design strategies
• Municipal bond-yield calculations
• Structure of exchange traded funds

P.J. Fischer has worked for 26 years at major Wall Street firms, most recently as the head of Municipal Research and Global Indexes at Bank of America Merrill Lynch, where he was also a member of the Bank's Research Investment Committee.

Su questo libro

Informazioni sull?autore

Dr. Philip Fischer is Managing Director, Municipal Bond Research and Global Indices at Bank of America Merrill Lynch. His areas of expertise include fixed income, especially municipal bonds, focusing on economic and market analysis.

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INVESTING IN MUNICIPAL BONDS

How to Balance Risk and Reward for Success in Today's Bond MarketBy PHILIP FISCHER

McGraw-Hill Companies, Inc.

Copyright © 2013 The McGraw-Hill Companies, Inc.
All right reserved.
ISBN: 978-0-07-180975-7

Contents

Chapter One

A Little History

America is a country that was formed by putting together a number of pieces. As the states came together, they gave—often grudgingly—the central government the powers it needed in order to operate. Of course, a lot has changed since the republic was formed, but understanding the basic outline of how the municipal bond market was created will tell us a great deal about what it looks like now and where it's going. Unlike corporations, which are actually formed by states, the states themselves don't go away when times get tough. And neither do their bonds.

MONEY, MONEY

When they came to America, the colonists didn't bring banks with them—nor did they bring much money, for that matter. The metal needed to make silver and gold coins was especially hard to come by in the colonies. Necessity, though, is the mother of invention. On December 10, 1690, the colony of Massachusetts was financially broke and facing rebellion by its soldiers, who had been sent on an expedition against the French in Canada. The colony expected that it could use booty taken in the campaign to pay the troops. Unfortunately, things did not turn out well militarily, but the troops still needed to be paid. The General Assembly came to the rescue by authorizing the printing of paper money for the colonial treasury.

Good ideas are rarely wasted. New Hampshire, Rhode Island, Connecticut, New York, and New Jersey authorized the printing of paper money in 1711. South Carolina (1712), Pennsylvania (1723), Maryland (1734), Delaware (1739), Virginia (1755), and Georgia (1760) then followed suit.

Of course, things quickly went out of control as the colonies printed more and more paper money. A wide variety of colonial paper money existed, some bearing interest and some not. Some was legal tender or was legal tender only when paid to the colony. In some cases, the devaluation created from printing so much paper was quite severe. For example, Rhode Island's currency depreciated by 96 percent in just a few years as a result of excess printing.

The colonies also fought to protect the market for their currency by passing laws to prevent the circulation of the other colonies' paper within their borders. Finally, in 1774, the English largely banned the use of colonial paper. These lessons weren't lost on the framers of the U.S. Constitution. Congress is explicitly given the authority "to coin Money, regulate the Value thereof," and the states are expressly prohibited from having their own monetary system: "No State shall ... coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts."

With the signing of the Constitution, the large debts incurred by the states during the Revolutionary War were assumed by Congress: "All Debts contracted and Engagements entered into, before the Adoption of this Constitution, shall be as valid against the United States under this Constitution, as under the Confederation."

Yet while the states gave up their power to print money, they did not give up the ability to borrow money. It is this capacity to borrow that lies at the heart of the municipal bond market.

Bear in mind that it is the states, and only the states, that have the inherent right to borrow. States engage in borrowing for a myriad of purposes. In addition, however, the states can, and often do, grant their political and economic entities—counties, cities, authorities, special districts, and so on—the authority to issue debt under certain circumstances. The states frequently specify the maximum amount that their political subdivisions can borrow, the method of repayment, what the borrowed money can be used for (the use of proceeds), and a myriad of other details.

The Constitution has this to say about the states' use of their borrowing authority: "No person shall ... be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation."

What constitutes "due process" changes with the context, but in general, the government can levy taxes or take property only for public purposes. (Public purposes is itself a term of art, and it can sometimes be broadly defined.) In addition, when property is taken, the owners must be fairly compensated.

Rights created by contract are a form of property and are subject to public taking, which means that a state is not forever bound by the terms of a bond contract. On the other hand, if the state acts to alter the contract to the disadvantage of the bondholder, it is obliged to fairly compensate the other party. However, if the state's actions don't harm the bondholder, or do so in only a minor way, the courts will be reluctant to intervene.

States are also constitutionally required to observe their contracts. The "contract clause" in the Constitution specifies that no state may pass a "Law impairing the Obligation of Contracts." Without this contract clause, bondholders would have to confront the general rule that one legislature cannot bind succeeding legislatures. This is logical; otherwise, we would still be living under Puritan laws from the seventeenth century. But when the legislature's intent is clearly to impair the value of an investor's rights, a court can force the state to observe its original agreement without regard to subsequent laws.

DEFAULTS ON OBLIGATIONS ARE NOT BANKRUPTCIES

States and local governments cannot simply ignore their debt obligations. Nevertheless, a lender to a state, like any lender, faces the possibility that the borrower could suffer financial difficulties and be unable to pay what is due on time. Defaults on municipal bonds are unusual but not unheard of. It is important to understand, though, that a default is not a bankruptcy.

Defaults occur when an agreement in the bond contract is not met. These failures to meet an agreement are divided roughly into monetary defaults, which are serious, and others, which are technical. A monetary default is the failure to make a payment on time. The payment can be an interest payment or a principal payment. Usually it has to be overdue by a fixed period of time, such as 30 days, to be considered a default, but any missed payment can immediately have very serious consequences.

A technical default is any nonmonetary default. These could include the failure to maintain the property built with the loan in an agreed-upon manner, the failure to keep reserve or other funds at a specified level, or the failure to submit reports to the lender within a fixed period of time.

The important thing is that a default can be cured or fixed. Usually the lender and the borrower work things out; if they do not, the parties will usually resort to a judicial procedure, such as appealing to a federal judge in bankruptcy to supervise the process of the lender and the borrowers' coming to terms.

STATE AND LOCAL GOVERNMENT BORROWING

Even at this early point in the book, it is important to note that state and local governments have, in general, been very responsible borrowers. Access to the capital markets is a key element of public policy. One of a government's more important jobs is to borrow money to pay for capital projects. In theory, a state can merely save up the tax payments it receives to build a public facility like a highway. However, these projects are expensive. Using a "pay-as-you-go" approach like this means that a large amount of money ends up sitting in the government's bank account, which can create political problems.

Suppose, for instance, that the state wants to build a road. If the road is in the western part of the state, the residents of the eastern sector may not think it fair. In addition, unions and others may seek to divert some of the money to other purposes that they deem worthy. And taxpayers know that public funds have a way of walking, and so they resist being taxed to enable the state to accumulate a lot of money. Also, the capital project often has a longer life than most taxpayers, so the current residents may not want to fund the next generation's needs.

Borrowing the capital to build an asset like the road is often the preferred approach. This is a "pay-as-you-use" method in which the actual users pay for the road as they use it. A pay-as-you-use method also provides an equitable solution for mobile populations. The current taxpayers usually don't want to be taxed to benefit outsiders. Cities and states that have taxed themselves heavily to provide facilities and services can find themselves a destination for out-of-state migrants from poorer areas who are attracted by the better infrastructure. Even without more facilities and services, some states will naturally be a magnet for immigration, imposing costs on the current residents.

The law is clear that a state must admit Americans from other states. This was made poignantly clear in the Depression-era Okie cases. During the Dust Bowl, indigents who had been forced off their farms in hard-hit states like Oklahoma often headed to California. However, when they arrived, they were frequently either turned away at the state border or arrested. And anyone who brought the poor into the state was also liable. Consider California's anti-Okie law:

Every person, firm or corporation, or officer or agent thereof that brings or assists in bringing into the State any indigent person who is not a resident of the State, knowing him to be an indigent person, is guilty of a misdemeanor.

The U.S. Supreme Court invalidated the law and made it clear that "poverty and immorality are not synonymous."

Citizens of the United States can live wherever they want in this country. As noble as this policy is, it is not without its consequences for public finance. Pay-as-you-use is a critical tool for handling the impact on infrastructure and taxes that migratory populations create. However, pay-as-you-use requires access to capital markets, and that, in turn, requires the borrower to be creditworthy. This is a point that is well understood at the state level.

RATINGS ARE A GOOD GUIDE FOR CREDIT WORTHINESS

Moody's Investors Service, one of the oldest bond-rating firms, gives a good picture of the creditworthiness of municipal borrowers. Over the years, it has produced studies examining the performance of bonds rated by the firm. In a recent study, Moody's sampled the period from 1970 to 2011. The sample contained 1,500 ratings in 1970, which expanded to about 17,700 in 2011.

Over the course of this 41 years, Moody's reported 71 monetary defaults in which the issuer failed to pay interest or principal. Other studies define defaults somewhat differently, including occasions when the issuer drew funds from a reserve account, for example. But it is a monetary default that investors would be most concerned about. Bonds that were not rated defaulted more frequently, but these nonrated bonds constitute a small part of the market and investors can avoid most of the default risk in the market by merely buying rated bonds.

Of course, in periods of financial stress, municipal issuers are likely to experience problems with tax revenues, but this tends to happen with a lag. During recessionary periods, their revenues decline, even after the recession is over. Moody's reported that in 2010 and 2011, after the Great Recession had officially ended, defaults rose to 5.5 per year, whereas the average number of defaults from 1970 to 2009 was 1.5 per year.

Municipal bond defaults also tend to be concentrated in a few types of bonds. Healthcare- and housing-related borrowing had the most defaults, 73 percent of the total. Still, the numbers are not huge for rated bonds: 29 defaults for housing and 23 for hospitals.

The bonds sold by cities, counties, and other state subdivisions that were repayable from the taxes of the issuer rarely defaulted and constituted only 7 percent of the sample's defaults.

If an issuer has problems, the lender's difficulties don't end there. The ultimate recovery in a default usually involves a return of some or all of the principal. With municipal bonds, the average recovery is around 65 percent of principal, although it varies greatly by the type of bond, and it may take some time to get the money returned. With corporate bonds, it is about 49 percent.

These results are for rated bonds and are generally consistent with the findings of other rating agencies when they examine the defaults on the bonds they rate. However, the issuer pays for the rating, and as a result many bonds are not rated—either because it is not economical to pay for a rating for a small issue or because the issuer would not like the rating it would receive. For investors who lack either the expertise or the time to keep track of an issuer's creditworthiness, the advice is generally either to buy rated bonds and keep track of the ratings, or to have the bonds professionally managed by a fund manager.

Municipal bond raters have had a relatively good record. Ratings of municipal bonds have been more reliable than those of taxable bonds, although the history of ratings for municipal bond insurance companies is difficult to defend. Municipal bond rating is a specialized segment of the bond rating industry and has shown itself to be far more accurate than mortgage bond rating, for example. Municipal bond ratings have been a useful guide for investors, although, as we will see, the standards for selecting the rating grade have been recalibrated in recent years to be more consistent with the scale used for corporate bonds.

No one is perfect, though, and the overriding rule is not to keep all of one's eggs in one basket. Diversification, even in relatively safe instruments, is always the best advice.

MUNICIPAL BANKRUPTCY

States are sovereigns, and lending to sovereigns is a problem because they can control the rules of the game by refusing to be sued, restricting suits to their own terms, or limiting the time within which a legal claim can be filed. In addition, both the nature of the claim and the amount of the damages can be limited. However, the constitutional reassurances discussed earlier give investors some comfort that the states and localities cannot merely legislate their way out of their debts.

All of that is fine, but what happens if the state or local government simply runs out of money, and the issuer and the lenders cannot agree on a resolution? In that case, a lender may seek help in court. One of the oldest remedies for forcing a governmental body to pay what it owes is a mandamus action. In general, such an action does what it sounds like: the court mandates that the officials of a governmental unit do what they are supposed to do under the agreement. Its use is often written into the documents of the lending agreement. Here is some sample language from a lease agreement:

Lessor must first seek through a mandamus action to enforce the payment of the Rent Payments due hereunder by the levying of ad valorem taxes, without limit as to rate or amount.

In other words, the person who is leasing the property, the lessor, has to go to court and ask the court to compel the governmental unit to make the payments due on the lease by increasing property (ad valorem) taxes as much as necessary.

Mandamus suits in municipal bonds have a long and checkered history. In the Reconstruction of the South after the Civil War, the administrators from the North were often highly unscrupulous in their issuance of municipal debt. The citizens were so incensed that they refused to make payments on the bonds. They didn't just default; they repudiated the bonds, saying that their issuance was null and void in the first case. Mandamus suits by out-of-state bondholders were of limited value when the court sought to compel local officials to pay and a different mayor showed up each day.

Mandamus is basically a state court remedy. There is now also a federal remedy allowing lenders to recover damages, but the lenders' rights are limited. The U.S. Constitution specifically authorizes Congress "to establish ... uniform Laws on the subject of Bankruptcies throughout the United States." Because the Constitution grants the authority to create bankruptcy provisions to Congress, states are preempted in this area and can't have their own conflicting bankruptcy laws. The U.S. Constitution is the law of the land. When the Constitution grants Congress power to act, no state law can overrule it. And Congress is empowered to pass bankruptcy laws.

Congress has used this authority to create an extensive legal system to help debtors and creditors in times of crisis. Most people are familiar with its basic elements. The Bankruptcy Code (Title 11 of the U.S. Code) is broken down into chapters. The three that usually come to mind are those that generally apply to wage earners (Chapter 13 of the code), corporate reorganizations (Chapter 11), and liquidations of individual and corporate property to pay creditors (Chapter 7).

State and local governments are not covered by these provisions. In fact, the states themselves are not authorized to file for bankruptcy. There have been proposals that the states be allowed to file for bankruptcy, but that is widely regarded as bad policy. The mere existence of a right to file for bankruptcy would introduce a new and very serious risk for municipal bondholders, who would demand to be compensated for it. The compensation would show up as higher borrowing costs for the states and for local governments. As a result, the states themselves have campaigned against allowing states to file for bankruptcy.

In addition to states not being allowed to file for bankruptcy, the contract clause prohibits states from legislating their way out of problems with their debts and the debts of their subdivisions. Thus, when a city is in financial trouble, the state cannot simply pass a law invalidating the city's debts.

Normally, bankruptcy proceedings for local governments are not a significant issue, since very few of these entities actually need them. The Great Depression, however, created such dire economic circumstances that Congress created a provision in the Bankruptcy Code to help cities, counties, and other units of local government manage their debt problems. During the Depression, there were situations in which a municipality would seek a mutual agreement among all of its creditors for a specific remedy or a payment schedule, but one or more creditors would hold out for a better deal. Neither the state nor the municipality could force the creditors into an agreement because of the limitations they had under the contract clause. Congress deemed that some form of federal remedy was needed; thus Chapter 9 of the Bankruptcy Code was created.

(Continues...)

Excerpted from INVESTING IN MUNICIPAL BONDSby PHILIP FISCHER Copyright © 2013 by The McGraw-Hill Companies, Inc.. Excerpted by permission of McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Dettagli dell'edizione

• Editore: McGraw Hill
• Data di pubblicazione: 2012
• Lingua: Inglese
• ISBN 10: 0071809759
• ISBN 13: 9780071809757
• Rilegatura: Copertina rigida
• Numero di pagine: 283
• Contatto del produttore: Messaggerie Libri; ufficio.anagrafiche@meli.it; ; Via Verdi, 8.; Assago Milano; 20090; Italia