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De-Risking Municipal Bond Portfolios

Escrowed to maturity municipal bonds can be thought of as "tax-exempt" U.S. government bonds.

bantam inc jack duval de-risking municipal bond portfolios - new york certificate

New York State municipal bond certificate.

As I’ve written about here and here, environmental, pension, and healthcare costs are posing increasing risks to municipal bonds and their issuers.  Most investors, and their advisors, are unaware of these risks.

Ways to De-Risk a Municipal Bond Portfolio

Investors would be well served to de-risk their municipal bond holdings before these risks manifest themselves in a systemic manner.  Some techniques to reduce risks include:

  • Diversification:
  • Buying Insured Bonds;
  • Buying Escrowed to Maturity (“ETM”) Bonds.

I’ll unpack each of these methods below.

De-Risking with Municipal Bond Portfolio Diversification

Since I’ve covered this in detail here, I won’t spend a lot of time on it in this post.  However, it bears repeating that most investors are heavily concentrated in municipal bonds issued by their home state, if not their home city.  While this has a slight tax advantage, it is an uncompensated risk because a similar yield could be generated while taking less risk.

This is an unforced error and any losses from such needless concentration are self-inflicted.

De-Risking through Insured Municipal Bonds

Bond insurance is a form of “credit enhancement” where the insurer stands behind the bond issuer ready to continue the payment terms in the original bond indenture if the issuer cannot make the required payments.

As a rule of thumb, investors should not buy bonds that have insurance if they would not otherwise buy the bonds.  For example, if a bond has a poor underlying credit rating (the rating without the insurance), and that bond would be too risky for the investor on a stand-alone basis, she should not purchase the bond just because it has an insurance wrapper on it.

Bond insurers can, and have, gone bankrupt.  In these instances, the bonds they insured decline in value as the insurance behind them becomes worthless and they trade purely on the underlying creditworthiness of the issuer.

Investors who do purchase insured municipal bonds need to know the credit quality of the insurers and must diversify both the bonds purchased and the insurers behind them.  That is, you don’t want a portfolio of municipal bonds insured by one carrier.

About 19 percent of all municipal bonds are insured, so a portfolio can be built of insured municipal bonds relatively easily.

Stresses on Bond Insurers

As the structural costs of pensions, health care, and environmental risk mount for all municipal bond issuers, there will be more defaults.  This will have a number of second-order effects, including:

  • Bonds insured by weakened carriers will decline in price as the value of the insurance is reduced;
  • Bond insurance will become more expensive;
  • Interest rates will increase for almost all issuers, as creditors demand higher rates to compensate for higher risks;
  • Bond insurers will be stressed by increased defaults and will likely experience some defaults themselves. If this becomes severe enough, bond insurance could become a thing of the past.

Because of these issues, bond insurance is the least secure of the three methods of de-risking municipal bond portfolios over the long-term.

De-Risking with Escrowed to Maturity Municipal Bonds

ETM bonds are a type of refunded bond in that the funds to pay the principal and interest payments due have been set aside in an escrow account.

In order to understand ETM bonds, it is necessary to understand the two different types of advanced refundings: prerefunded and ETM.  The Municipal Securities Rulemaking Board writes the following:[1]

Bonds are “escrowed to maturity” when the proceeds of the refunding issue are deposited in an escrow account for investment in an amount sufficient to pay the principal of and interest on the issue being refunded on the original interest payment and maturity dates, although in some cases an issuer may expressly reserve its right (pursuant to certain procedures delineated by the SEC) to exercise an early call of bonds that have been escrowed to maturity.

Bonds are considered “prerefunded” when the refunding issue’s proceeds are escrowed only until a call date or dates on the refunded issue, with the refunded issue redeemed at that time. The Internal Revenue Code and regulations thereunder restrict the yield that may be earned on investment of the proceeds of an advance refunding issue.  (Emphasis added)

Escrowed to Maturity bonds are typically backed by government-issued securities such as U.S. Treasury bonds and strips.  In this way, the municipal bonds have been “turned into” Federal government tax-exempt bonds.

In almost all instances, whatever the rating on the underlying municipal bond, after being escrowed to maturity, the issue will be rerated AAA or AA+ because the obligations of the bond can be satisfied by the escrowed funds irrespective of any tax collections or revenue streams that would normally have been used for payment.[2]

When buying ETM bonds, it is critical to insure that all the sinking fund and any other call features have been defeased.  As with all advance refunding bonds, the collateral should be examined for quality.  Finally, potential purchasers should also review the escrow agreement.

Less than one percent of all outstanding municipal bonds are ETM, so it would take longer to build a portfolio of them.  However, with patience, they can be found.

De-Risking by Combining Techniques

Diversification can always be utilized and is a virtual free lunch.  It can, and should, be used in conjunction with a portfolio of insured or ETM bonds.

Portfolios invested in a nationally diversified manner and utilizing insured or ETM bonds are more likely to withstand systemic shocks.

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Notes:

[1]      MSRB s.v. “advance refunding”; Available at: http://www.msrb.org/Glossary/Definition/ADVANCE-REFUNDING.aspx; Accessed October 28, 2018.

[2]      In some instances an ETM bond will have its ratings withdrawn and will trade unrated.  If the escrow funds are invested in U.S. government obligations, investors can look through the non-rating and to the rating of the escrowed securities, which are typically rated AAA or AA+.

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