BOND INVESTORS' FORUM Welcome to FMSbonds.com’s
Bond Forum tm, an exclusive opportunity for investors to submit questions
and comments to municipal bond specialists. If you would like to participate,
or wish to comment on one of our Commentaries,
Strategies or Bond
Analyses, simply send us an e-mail.
There is no charge, nor is any kind of registration required. We
know of no other service of its kind. We post initials, not names, and ask that you include in your e-mail your
state of residence. Posted e-mails may be edited for length and clarity. Responses are
provided by James A. Klotz, the president and co-founder of FMSbonds, Inc.,
a municipal bond specialist for more than 35 years; Dr. Jay H. Abrams, chief
municipal credit analyst; and other members of the firm as noted.
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Tax-free bonds for stadium
We'd like to build a new stadium for a municipal government and have them lease it from us. Is there a way to accomplish this with tax-exempt bonds?
B.K., Indiana
Dr. Abrams responds: This has been done in a number of localities. There are a number of basic questions that would need to be answered, including: source of revenues to repay the bonds; terms of the lease; "essentiality" of the facility to the municipality; and others. You would need to consult a tax attorney to review the guidelines that would affect such a financing. Recent financings of this type were done by New York City for new stadiums for the Mets and Yankees.
04/23/08
Tax-free bonds for housing
Charles Rangel, D-N.Y. has just introduced a housing bill that would permit tax-exempt bonds to be guaranteed by Federal Home Loan Banks and permanently exempt mortgage revenue bonds from the alternative minimum tax. How likely is it that the bill will be passed, and if passed what effect will it have on both existing municipal bonds and those that are issued in the future?
S.K., New York
Dr. Abrams responds: Please see our article “House considers easing rules on issuing tax-free bonds.”
4/23/08
Auction rate securities
UBS is going to mark their clients' auction-rate securities. Do you have any idea how they are going to value a security that has no bids to buy?
J.P.
Mr. Klotz responds: Good question! According to what we are reading, UBS is planning to price these securities based on an "internal computer model." Since they have not indicated their willingness to purchase these securities at these marked down prices, we would guess this is a symbolic action taken out of concern for future legal liability.
4/1/08
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What effect will the lack of participation in the short-term bond auction in Colorado have on the Colorado municipalities, which will have to now pay much more in interest? If they cannot pay, what will happen?
G. F, Colorado
Dr. Abrams responds: There is no standard answer that holds for all issuers, either in Colorado or elsewhere. Each issuer that utilized this interest setting format would have to be analyzed independently in order to assess its ability to fund obligations under the circumstances you cite.
As you know, bond ratings for different issuers differ partly based on financial performance. Issuers with stronger liquid fund balances would be more likely to withstand interest rate "shock" from auction failures. At present, if Colorado issuers are having difficulty meeting payment obligations, we have not heard of any. Each credit would have to be analyzed on its own merits to determine whether its exposure to an interest rate spike is problematic.
4/1/08
Closed-end funds
I was surprised by your Bond Forum item (“Disappointed in closed-end bond fund”, below). I believe your statement that closed-end funds are experiencing a wave of redemptions is not quite accurate. The basic premise of a closed-end fund is a finite number of shares and to trade in the market at a price that is either connected or disconnected to the net asset value of the fund. Should someone wish to sell their share, they do it in the marketplace. At times, there may be more sellers than buyers or buyers than sellers, which can cause the discount to widen or narrow to the net asset value. As a registered investment advisor who specializes in the closed-end format, we have found that our selection of closed-end funds can and does beat benchmark returns over longer periods of time or an interest rate cycle. Diversification is a key ingredient that closed-end funds afford the individual investor along with professional management. Purchasing a fund at a discount further adds to current returns. Tax efficiencies are more profound that individual bonds. The auction rate preferred shares used for leverage have been involved in failed auctions, which can create a higher cost of leverage for the funds, but is starting to stabilize according to historical averages.
S.T., New York
Mr. Klotz responds: We agree that we could have phrased the quote in question a little better, but we see the difference as semantical rather than fundamental.
The decline in closed-end fund prices, which we blamed on redemptions, is really caused, as you say, by "more sellers than buyers," which in the days before listing these funds on an exchange would have been called "more redemptions than sales."
Either way, it reflects investors exiting these funds.
Although you seem quite sanguine regarding failed auctions, we are not sure that investors who can't get their money out of these preferred shares take solace in the fact that these funds are "starting to stabilize according to historical averages." In fact, the flood of e-mails we have received reflect quite a different attitude.
Right or wrong, many investors feel they were misled by their brokers and financial advisors, who promoted these preferred shares as "cash or cash equivalents."
We understand that a number of closed end funds are arranging financing to correct this problem. However, the trust that was lost will not be easily regained.
We are not aware of the "profound" tax advantages that closed-end muni funds enjoy over individual municipal bonds, but we would be pleased to hear more on this subject.
4/1/08
FGIC
Could you discuss the latest regarding the insurer, Financial Guaranty Insurance Company (FGIC)? They appear to be in run off now, and according to latest reports, may be "taken over" by the state of New York given their inadequate capital reserves. Can New York state regulators sequester the capital reserves and unrealized premiums of FGIC's muni book, thus protecting the insurance coverage on their municipals from further losses from the non-muni book?
M.G., California
Dr. Abrams responds: FGIC was downgraded to “BBB” with a Negative Outlook by Fitch Ratings on March 26, 2008. The rating change reflected Fitch's belief that FGIC's $5 billion of claims paying resources meets the rating agency's guidelines at that level, but no longer is sufficient for a higher rating. Fitch indicated that according to its internal loss models, FGIC is short by $5.1 billion to $5.3 billion to be a “AAA” insurer, as they once were.
On the positive side, Fitch noted that FGIC has ample liquidity, and most Collateralized Debt Obligation-related claims the insurer may need to ultimately pay will likely be spread over a long time horizon. While not the best of circumstances, a “BBB” rating does indicate adequate capacity to meet financial obligations. Further, FGIC tended to write insurance business in municipal sectors that are among the safest, i.e., water and sewer bonds and general obligations.
FGIC intends to remain in business with a focus on the less risky business sectors, such as global municipal finance. FGIC has announced a moratorium on writing new business to allow time to rebuild capital, and establish a new licensed insurance entity through which future municipal business would be transacted.
The amortization of existing insured bonds will allow capital to accumulate as bonds mature. Meanwhile, FGIC is seeking, through the courts and other means, to reduce its exposure to CDOs. Fitch believes that FGIC's rating will not stabilize until capital is rebuilt and the insurer's exposure to CDOs is capped.
Finally, we do not believe that FGIC's municipal book can be isolated from its CDO woes. That is the reason the downgrades of FGIC have taken place. The rating agencies assume that current resources must be available for both municipal and mortgage related claims.
If FGIC is successful in establishing a new organizational vehicle to write municipal business, it would likely be able to segregate resources for that purpose.
4/1/08
Safe areas for California munis
I'm a portfolio manager at a bank trust department in Southern California. What do you think are the safest areas now for California munis, and the least? How would General Obligations rank? We deal primarily with Southern California clients; and manage about $700 million total (equities and fixed) for a variety of high-net-worth corporate and institutional clients. I would appreciate any input you could provide. You guys have a great Web site!
D.M., California
Dr. Abrams responds: When seeking to determine which California tax-free bonds are "safest," it would help to define the term.
In regard to credit quality, higher rated general obligation bonds are traditionally considered the least likely to default. Lower rated securities for non-profit organizations, solely supported by their own revenues, generally indicate greater risk.
The key factor in determining credit risk for any bond is the "essentiality" of purpose of the issuing entity. We always assume that the more essential the public purpose of the issuer, the more likely the efforts would be to insure its survival and that it meets its financial obligations.
In the current volatile financial climate, it is worth noting that traditional municipal bonds have continued to pay principal and interest in line with historic patterns. Default studies have repeatedly shown municipal bonds have an extremely low probability of default. For a more specific response, it is necessary to examine the actual bond issues in question.
4/1/08
Muni fund
The value of my Oppenheimer Rochester Muni mutual funds has gone down. Do you think that the value will ever go back up and what would you do with mutual fund now?
J.S.
Mr. Klotz responds: Your Oppenheimer Rochester High Yield Muni Fund has historically been one of the better performing open-end mutual funds.
This fund does not employ leverage, as do closed-end funds, to enhance the yield. It does, however, own a substantial amount of bonds subject to the Alternative Minimum Tax (AMT), which have lagged behind the prices of non-AMT securities.
For the most part, your market values are suffering from the same conditions affecting the entire municipal market (see: "What's Up With My Market Values?")
As we have commented before, market value can be more problematic with bond funds because they have no maturity date, as do individual bonds, which mature at a stated time.
4/1/08
What is protected in bankruptcy?
I buy muni bonds through several brokerage firms, and the bonds are held by the firms. That is different than many years ago when the bond certificates were held by the investor and a transfer agent sent the bi-annual payment. If a brokerage firm like Bear Sterns did go bankrupt, would the “AAA”-insured muni bonds that they held for investors be safe and still pay as before, or would the dissolution of the firm include the value of these bonds? Who really owns the principle and who pays the interest on these bonds especially in a brokerage bankruptcy scenario?
N.G.
Matthew Guerrise, Senior Vice President – Compliance responds: Customer securities that are held in safekeeping by a brokerage firm are, by law, required to be held in segregated accounts.
In the case of a broker/dealer bankruptcy, customer cash and securities are protected from creditors. They are never considered assets of the brokerage firm. By law, these securities are the property of the customer, as well as any interest payments received or due. Misappropriation of customer assets is clearly illegal.
In a bankruptcy, the Securities Investor Protection Corporation (SIPC) steps in and acts as custodian for all customer assets. Membership in SIPC is required for all registered broker/dealers.
During this process, should any customer assets be missing, SIPC will replace those assets to the limit of $500,000 in securities, with a maximum claim limit of $100,000 in cash.
As an added measure of security, most firms carry additional coverage that protects customer assets above the basic SIPC limits. (Inquire about the limits where your brokerage accounts are held.)
The interest on your bonds will continue to be paid by the issuer. SIPC will be responsible for making the appropriate credit to your account.
4/1/08
I have a large municipal bond portfolio of which all issues are “AAA” rated and insured. In the past year, the market value of the portfolio has decreased below the face value by about $200,000. I know that as long as I hold the bonds to maturity, I will receive full face value at redemption. However, what controls the day-to-day market value of my portfolio, and why has it devalued so much over the past year?
J.G., Rhode Island
Mr. Klotz responds: Your first question is an easy one. Market prices on municipal bonds are set by the actual buying and selling of these securities. It is a supply and demand market.
Your second question is a little more complex. Over the past year, there are a number of factors that have affected the market value of insured municipal bonds. Most important has been the uncertainty over the future of municipal bond insurers, who ran into trouble insuring collateralized debt obligations (CDOs) which are structured investment vehicles containing subprime mortgages.
Because of these problem mortgages, the rating agencies have threatened to downgrade some of the “AAA” insurers, and some have actually lost their “AAA” rating.
I am sure you are aware that these subprime mortgage securities have also created billions of dollars in losses for the major Wall Street firms. The result of these losses is firms, who always lent support to the municipal bond market, have now become net sellers of municipal bonds to enhance their own liquidity.
The most recent problem facing the market is a result of the dysfunction of auction rate securities (floaters). These floaters, typically considered short-term instruments because investors could withdraw their money through auctions on a short-term basis, have now, due to failed auctions, been forced to liquidate their long-term municipal bonds, further glutting the market with supply.
Lastly, because of the illiquidity in the market place, matrix pricing systems, utilized by all brokerage firms for month-end statement purposes, are struggling to assign values to investors' bond holdings. Don't be surprised if the prices you are concerned about understate the true value of your holdings.
Here is the good news: Municipal bonds continue to perform well and pay principal and interest on time, without the help of the beleaguered bond insurers. You didn't buy your bonds for capital gains, you bought them for the tax-free income.
The fact that municipal bonds are providing higher yields today in comparison to their taxable brethren should be viewed as an unusual buying opportunity for municipal investors.
3/17/08
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I enjoy reading your commentary. I got into munis some years ago thanks to my parents (now gone), who accumulated a nice portfolio of insured munis that just kept paying interest year after year – at least until they were called. Although I see some very good deals today, I don’t have a lot of spare cash. I've been thinking about where all this will lead, and it seems that if today's unusually high yields were to return back to normal, then the bond prices would have to rise. So buying today gets you a period of high income, plus the possibility of capital gains down the road. I know you counsel to "buy bonds for income, not capital gains,” but am I correct on this? The possibility of capital gains could be an added incentive to me, since buying now would stretch my free cash.
S.D., Connecticut
Mr. Klotz responds: You are right on the money. Tax-free bonds have never represented greater value than they do today when compared with U.S. Treasury bonds, which have always been the benchmark for this analysis. We outlined the reasons for this in our recent commentary, “What's up with my market values?”
3/17/08
Bonds continue to pay
There has been a lot written about the capitalization shortfalls of the bond insurers leading to downgrades. Have the companies actually been forced to make any payments yet? I haven't read anything about this yet. Also, if a muni bond is escrowed to maturity and the issuer declares bankruptcy, is the bond still protected?
M.M., California
Mr. Klotz responds: The vast majority of municipalities with insured bond issues continue to pay principal and interest without the assistance of the insurers.
The concerns about the monoline insurers have not been because of their municipal bond portfolios. Reserving against the collateralized debt obligations (CDOs), which are exposed to the troubled mortgage market, has posed the threat to the insurers' capital.
When bonds are escrowed to maturity (ETM), they are secured by Treasury securities. Once these bonds are escrowed, they are no longer the obligation of the original issuer. Therefore, they would be unaffected by the issuer's bankruptcy.
3/18/08
Valejo, California
I heard that City of Valejo, California went bankrupt. What now happens to their insured and non-insured bonds? Who pays what and how much? It would be interesting to know as this could play out again.
K.D., Wisconsin
Dr. Abrams responds: As Mark Twain was reported to have said, "the reports of my death are premature." Vallejo has, indeed, experienced severe financial deterioration. A Chapter 9 bankruptcy filing has been contemplated, but was averted this week when the City Council passed a fiscal emergency plan and reached a tentative agreement with the police and firefighters' unions. The city faces a $13.2 million 2007-08 general fund operating deficit, and a negative $9 million fund balance.
Voters will be asked in November to approve a number of revenue raising measures, and the police and firefighters' unions will still be asked to approve a number of stiff rollbacks in pay and benefits to keep the city out of bankruptcy.
Assuming bankruptcy does not occur, bondholders should continue to receive their principal and interest payments as before. Insured bonds would continue to pay regardless of the city's fiscal status since the insurance policies on those issues are irrevocable. More murky would be the position of uninsured bondholders should an actual bankruptcy occur. Bondholders in Chapter 9 proceedings generally receive better treatment than would be the case under Chapter 11, used for commercial enterprises. In the few cases of municipal bankruptcies in the past, bondholders have typically recovered a significant portion of their investment after the issuer restructures its debt obligations. As of now, Vallejo will hopefully continue to avoid Chapter 9, to the relief of both its citizens and bondholders.
3/18/08
Auction rate securities
How does the situation with auction rate securities get resolved in view of the fact that at the moment, money cannot be redeemed?
D.K.
Mr. Klotz responds: That is a great question. It is being pondered by some of the best minds on Wall Street.
The major brokerage firms have a vested interest in finding a solution to this problem, since it is tying up the funds of some of its largest and most valued clients.
A number of independent trading networks (ECNs) are hoping to get involved by creating secondary markets to trade these securities. Forbes reported that trading was ready to begin at Restricted Stock Partners, an alternative trading site that specializes in thinly traded securities, along with Muni Center which is a municipal bond aggregator.
Interested buyers, however, will be seeking to buy these securities at distinct discounts.
This is obviously not an ideal solution, but may be a way out for investors who are desperate to recoup their funds.
Clearly, no one has come up with a viable plan to make investors whole on securities that were generally considered cash equivalent. We will try to provide more information as the situation develops.
3/17/08
Taxable interest that accrues on OID bonds
I'm studying how to calculate the taxable interest that accrues on original issue discount (OID) bonds. I have IRS publication 1212. I'm following the constant yield method. I understand both the concept and the math. I do not own an OID bond, and may never own one, but I'm curious about two things. First, if I buy an OID bond on the secondary market, and I pay a premium for it, is there any more "accrual" to be done? I would think not. It would seem that at the time of my purchase, the previous owner would have to declare all the additional money, above the face amount, as taxable income and then I would have nothing more to accrue. Second, if I buy an OID Bond, as above, but this time for a discount, do I accrue only from my purchase price up to the face amount? That is, I paid more for it than the previous owner's current adjusted price, but still less than the face amount.
K.K., West Virginia
Michael Seligsohn, CFO, FMSbonds, Inc. responds: An OID bond is a new issue that is usually offered below par, such as a zero coupon bond.
The taxable interest that accrues on an OID bond is based on its original yield at the time of issuance. The issuer, through its paying agent, will post the OID amount, which will then be reported by the holder (usually a brokerage firm or a bank) to the owner and to the IRS on Form 1099 OID. This income should be included as interest income on the owner’s tax return, and also added to the basis of the bond. As you noted, the bond may have been traded on the secondary market and owned at a discount (market discount) or a premium.
At the time of a sale or maturity there may be a gain or loss based on the difference between the proceeds received and the adjusted basis (original cost along with the additions to the basis). A complicating factor to consider at the time of sale or maturity is that the market discount (a discount to the accreted value at the time of original purchase) is considered ordinary income, and the other components of the gain or loss would be considered capital.
As always, we strongly advise consulting with your tax advisor regarding any tax matter.
3/17/08
Is this one of the best opportunities in a safe asset class that you have ever seen?
A.C., New Jersey
Mr. Klotz responds: Without question, and we are in very good company.
Bill Gross, "The Bond King," said Friday that munis are so undervalued, he is buying them for his Pimco Taxable Bond Fund. Warren Buffett was quoted on CNBC today as saying the best opportunities he sees right now are in bonds rather than stocks. We don't often hear this from Buffett.
At no time in history have municipal bonds yielded this much in comparison to Treasuries.
The main factor behind this disconnect in the markets comes from broker/dealers increasing their margin requirements for hedge funds. This is forcing the muni hedge funds to sell massive amounts of municipal bonds into an illiquid market.
Pimco Bond Trader Mark McCray was quoted as saying, "The muni market looks like an outstanding buying opportunity for investors who can take advantage of the chaos created by forced selling and fear. Munis are very, very cheap".
The reason these gentlemen are so excited about municipal bonds today is that the disruption in the market is not caused by credit concerns, but by the capitalization problems of the large Wall Street entities.
3/3/08
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It is the lack of liquidity in the 10-day preferred money market that was represented to be liquid that has lost its credibility. It is essentially fraud to represent a security to be liquid that is not. How does one ever trust a broker that sold these?
K.M., Washington
Mr. Klotz responds: Your point about trust is well taken. We were surprised ourselves to discover that many brokerage firms listed these auction securities under "cash and cash equivalents" on their monthly statements. We don't know if this is fraud, but it is obviously misleading.
Unfortunately, too many stock brokers marketed auction securities as money market funds simply because they didn’t understand the true nature of these instruments. These “short-term securities,” in reality, were actually mutations of long-term municipal bonds. Sooner or later, form rears its ugly head.
3/3/08
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Just wanted to say I haven't had this much fun since my father began buying munis 30 years ago. I was fortunate to have had some cash from six months of calls and maturities to invest in the past month, much of it from FMS. Some of my purchases are down as much as 10% from prices of a month ago. The underlying credit is my guide. Please continue to craft your lucid explanations. I enjoy and appreciate them.
M.K, Texas
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Good article, thanks. At least I'm not the only one wondering what's going on the past two weeks!
M.F., New Jersey
Disappointed in closed-end bond fund
I just discovered your Web site, and I must say, your service is a godsend! Back in May, we inherited some money and wanted to put it in a "safe place." My financial advisor recommended a closed-end bond fund. Since I trust my financial advisor, I took his advice without doing a great deal of research. I was also put at ease when I learned that he was heavily invested in the same fund. So far, we’ve been very disappointed. We are not in a position to lose any more money in this. I am using this inheritance to care for my elderly mother, who unfortunately did not plan or save for her own retirement. We will need to sell some of our shares early next year. I am very concerned about this downward trend in my muni bond fund and I'm not sure I can stomach riding it down to the bottom (unless we're already there or close). My financial advisor recommends that I stay put, but I have been feeling the panic to get out and perhaps buying back in if these funds ever reach the deep, fear-induced discount that some are prophesying. I keep having this recurring nightmare that I am the last person stuck with some permanently devalued paper! The seemingly irrational loss of confidence in the muni bond market is seriously compromising its value.
J.S.
Mr. Klotz responds: We fear your financial advisor may be understating the problems with closed-end bond funds.
Closed-end bond funds differ from open-end funds and individual bonds by employing leveraging strategies to create "better-than-market" returns. This means they borrow on a short-term basis and invest in long-term bonds.
The short-term borrowing is done through the use of auction rate securities (floaters), which are sold to large investors with the promise of easy exit by way of regular auctions. Lately, however, as you may be reading, the majority of these auctions have been failing. Because these short-term investors are concerned they may be unable to have their principal returned to them, they are no longer willing to provide this short-term financing.
Many of these funds are now experiencing a wave of redemptions. The funds can be forced to liquidate their long-term securities to accommodate these redemptions. Unfortunately, the result is, these funds are now producing greater-than-market losses.
Whenever possible, we recommend investors own individual bonds rather than bond funds. Because the individual bonds have a stated maturity date, they have a tendency to maintain a more stable market value.
3/3/08
Underlying rating
Where can I get the underlying rating of a muni bond?
L.F., Florida
Mr. Klotz responds: Since issuers are charged a fee by the rating agencies to rate their new issues, they usually do not request that their underlying credit be rated if the bond was assigned an insured rating.
Frequently, issuers also have uninsured bonds outstanding. The rating on these issues can often provide a good indication of the issuer's credit quality.
We use Bloomberg Information Services for this information. Unfortunately, this is an expensive proposition and can be impractical for an individual investor.
3/3/08
Thanks for common sense
Too bad more people don't have common sense like you do. If they did, they wouldn't be so worried. Thanks for all the good deals I've gotten from your company.
P.C., New York
California’s latest budget battles
Does the current disarray in the muni bond market present a buying opportunity for California residents? I foresee very difficult times over the next 10 to15 years for California’s economy, So whether buying long-term California muni bonds is a safe, prudent thing to do at this time is not clear to me.
J.K., California
Mr. Klotz responds: We have a more optimistic view about the economic future of the State of California. We believe that California General Obligation bonds yielding over 5.00% tax-free will prove to be an excellent value. To avoid undue concentration, you may want to consider bonds issued by U.S. territories, such as Puerto Rico or Guam, which are exempt from federal and state taxes.
3/3/08
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I am currently invested in FRCIX (Franklin California Insured Municipal Bond Fund). Although it has fluctuated somewhat over the past 6 years, the past few weeks have been somewhat unusual. The fund continues to drop each day at a higher rate than in the past. I know a lot is going on in the market right now. However, is there anything specific with this fund that I should be worried about?
V.C., California
Mr. Klotz responds: We don't think there is a reason to be overly concerned about your California bond fund.
There are a variety of market factors today making it difficult for funds of this type to mark their securities to market (price their bonds), which is required on a daily basis.
California is making headlines once again due to budget concerns. Insured bonds have been volatile due to downgrades and threatened downgrades of the bond insurers.
Bond funds, because they have no maturity date, have a tendency to be less defensive in the marketplace than individual bonds.
As always, we believe these conditions will prove to be transitory. Remember, you bought this investment for the tax-free income. If swings in market value become too disturbing, you may want to consider a switch to individual bonds with a specific maturity date.
3/3/08
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How would California's budget crisis affect the California muni bond market? I have a large investment in individual bonds through FMSbond as well as in muni bond funds. I am worried about possible defaults.
M.S., California
Mr. Klotz responds: As you know, this is not the first budget "crisis" experienced by California.
As a matter of fact, budget problems in 2002 led to Governor Schwarzenegger's election. At that time, Standard & Poor's cut its credit rating on California General Obligation bonds from “A” to “BBB.” We were inundated with e-mails from our west coast clients asking if they should dump their California bond holdings. We responded by saying, "We think California residents should be buying, not selling” - particularly general obligations of the state.
California General Obligations are secured by the full faith and credit of the state. This pledge is supported by the state's "ad valorem" taxing power. Ad valorem taxes are based on the assessed valuation of real property. California boasts some of the most valuable real estate in the country.
Investors who took advantage of this advice were able to purchase these bonds at tax-free yields exceeding 5.25%. Subsequently, California was upgraded by the rating services as that "insurmountable" crisis passed. We expect a similar result this time.
02/25/08
State ratings criteria
What is the best source of information on Triple-A bond rated states? So far I have determined that Moody's, S&P, Fitch seem to be the ratings that carry the most weight, but I am more interested in knowing the factors used to determine the rating states receive and which states have the highest rating.
W.B.
Dr. Abrams responds: Each rating agency uses somewhat different criteria in establishing state ratings. I would suggest that you contact the rating agencies or check their Web sites for the information you need. While the agencies charge for ratings and analysis, much of their rating methodology is available on their sites for free, including the factors that go into a general obligation rating. If you call the rating agencies and ask for a list of state ratings for research purposes, they will most likely accommodate your request
02/25/08
Confirming your e-mail
I have enjoyed your Bond Forum for years and have occasionally submitted questions and/or comments. In the past few months, I submitted questions and received an e-mail from FMS thanking me for my interest and asking me to somehow register with you, though you state clearly on your Web site that readers can send e-mails without any sort of registration. Please explain.
A.B., Pennsylvania
Mr. Klotz responds: We do not require visitors to register. The e-mail you received merely asks visitors who’ve requested information from us to confirm their request. The purpose of this e-mail is to ensure that our communications by e-mail are not considered "spam" by the recipients, and are not treated as such (clicking on the spam button).
We only send e-mails to people who have requested us to do so. Nevertheless, some people have a tendency to forget they have submitted an inquiry sometime in the past. The process we are implementing is designed simply to ensure our ability to send e-mails to those who request them.
02/25/08
Buffett’s bet
Do you think Warren Buffett's offer to reinsure muni bond insurers will impact the muni bond market?
M.S., California
Mr. Klotz responds: Please see our article, “Buffett Sees Munis as a Good Bet”.
We don't think the Buffett proposal will have any impact on the municipal bond market. In our opinion, none of the insurers can accept this offer. He is suggesting the insurers turn over the least risky and most productive portion of their insured portfolio while retaining the subprime CDO junk that caused all the problems in the first place.
This is not a bailout of the insurers. It's a deal that would allow Berkshire to collect premiums to insure bonds that for the most part don't need to be insured. Naturally, if one of the insurers accepts this proposal it will enhance the current market value of the reinsured bonds.
02/25/08
The Davis case and bonds from U.S. possessions
Could the tax-free status of Puerto Rico or other possession bonds change as a result of a decision in the Davis v. Kentucky case? Will we have to wait until June to get the Supreme Court's answer?
E.F., New Jersey
Mr. Klotz responds: There is nothing to worry about regarding the Davis case and your Puerto Rico bonds. The Davis case involves sovereign states taxing bonds issued by other sovereign states. Puerto Rico is a territory of the United States and will continue to enjoy freedom from taxation regardless of the decision in the Davis case.
02/08/08
Zero coupon bonds ideal for future needs
What are the pros and cons of zero coupon munis? I bought several when I did not need the income and hoped to leave them to my kids. Are they appropriate for this purpose?
E.F., New Jersey
Mr. Klotz responds: Zero coupon bonds are ideal for the purpose you described. Generally, they are best used to fund a future need, such as college tuition, retirement, etc.
Zeros are an excellent planning tool. They are purchased for pennies on the dollar, accrete at a specified tax-free rate and pay in full at maturity.
Be aware, since zero coupon bonds pay no interest until maturity, their prices will fluctuate more than other types of bonds in the secondary market.
02/08/08
General obligation vs. revenue bonds
Are general obligation bonds safer than revenue bonds?
J.P., Florida.
Mr. Klotz responds: Traditionally, general obligation (G.O.) bonds, because they are backed by ad valorem taxing power, have been considered the most secure debt in the municipal bond market. But this isn't always so.
To analyze the strength of a G.O. bond, one must be aware of the population, assessed valuations and the percentage of taxes collected versus taxes levied.
Revenue bonds, on the other hand, are issued for a specific project and are secured by the revenue derived from that project. The strength of a revenue bond is determined by comparing the income of the project to the cost of operation. This ratio is referred to as "coverage."
A revenue bond with exceptional coverage can often be stronger than a G.O. bond from a sparsely populated taxing district.
Broad classifications are not enough to determine the strength of an obligor. Each bond must be evaluated independently.
02/08/08 The Fed and muni bonds
How do interest rate cuts by the Federal Reserve change the yield on municipal bonds? Just trying to educate myself in this new market for me.
R.P., West Virginia
Mr. Klotz responds: There really is no direct effect on bond yields as a result of a Fed rate cut. The Fed's actions impact only the shortest interest rates on the curve (overnight, inter-bank lending rate). Basically, bond yields are determined by the buying and selling of the securities themselves.
02/08/08
Bond insurers and Puerto Rico bonds
It has been two months since you wrote “Don’t Lose Sleep Over Bond Insurers’ Woes” and things appear to have gotten worse for at least one bond insurer: Ambac. I am retired and have invested heavily in AAA-rated, insured municipal bonds, including some revenue bonds issued by Puerto Rico government agencies. I relied heavily on the AAA rating and insurance in purchasing the bonds. I have done some research online and found that some recently issued uninsured Puerto Rico governmental agency bonds have ratings of BBB-. This does not inspire confidence. Given the financial difficulties of the insurance companies, the potential for reduced value of these bonds and the fact that Puerto Rico bonds generally are not rated highly, should I worry about a default? I cannot afford to lose any money on these bonds. I bought the AAA-rated insured bonds for income, not capital gains and cannot afford to lose money on these bonds.
G.N., Oregon
Mr. Klotz responds: In our commentary, “Who’s paying your interest?”, we outline our view on some of the issues you raise. We don't think you should lose sleep over any of your bonds, including your Puerto Rico holdings. The default rate on investment grade bonds has been insignificant over the past 30 years. Because of the extreme negative publicity attendant to the bond insurers, bid prices on these bonds are not reflecting the true value of these securities. Our sense of things is this would be the worst time to sell any of your insured bonds. Further, keep in mind that Puerto Rico is a territory of the United States, which has its own implications. We think your insured bonds are going to be fine.
02/08/08
Fund lagged last year; what now?
I invested heavily in California tax-exempt muni-bond funds, mainly for income. They have not been doing very well last year in general. They seemed not to follow Treasury bonds closely. What is your outlook for this sector in 2008 in terms of yields and price?
L.J., California
Mr. Klotz responds: You answered your own question.
You bought these bonds for the tax-free income, which they continue to pay regularly.
The municipal market has failed to track the Treasury bond market for a number of reasons. The biggest factor has been the lack of demand from institutional investors, banks and hedge funds that have been mired in the subprime crisis.
The market value of your bonds is really irrelevant since you are not going to sell them if they move up or down.
Keep your interest clock ticking!
01/14/08
Account insurance
I assume brokers hold my municipal bonds in street name for easy manipulation. If the broker runs into financial difficulties and possibly goes bankrupt, are my bonds safe, segregated, or do they become part of his assets?
D.J., New York
Mr. Klotz responds: All broker/dealer members of FINRA maintain at least basic insurance coverage from SIPC. Basic SIPC coverage insures your account for up to $500,000, which can include $100,000 in cash. Most firms carry excess coverage on top of this. Your bonds do not become part of the brokerage firm's assets.
01/14/08
Income protection
We have $350,000 in CDs that are maturing and we are seeing a continuing decline in interest rates for the replacement purchases. We have no debt, but minimal income other than the CD interest. What is our best option to stay ahead of inflation and avoid taxes as much as possible? We are in our middle 70s. We cannot afford anything risky at this stage of our lives.
B.S.
Mr. Klotz responds: Unfortunately, rates on certificates of deposit are likely to continue declining if economists are correct about the U.S. economy slowing and the Fed continuing to push short term rates lower.
Depending on your tax bracket, you may want to consider taxable or tax-free bonds that provide reasonable call (income) protection.
Longer term fixed income securities, as opposed to short term CDs, will subject you to some degree of "market risk," but could eliminate your "income risk" for a reasonable period.
We would require more information regarding your personal financial situation in order to make specific recommendations.
01/14/08
Rating agencies raise bar on insurers
In your commentary from Oct. 3, 2007, “Moody’s Says Bond Insurers Can Withstand Subprime Risk,”you indicated that bond insurers could easily handle the fallout from the subprime mortgage mess. Yet, a recent newspaper article stated that, "MBIA may be on shaky ground" and that the rating services had issued an "ominous negative outlook." It seems that MBIA needs a massive infusion of capital to avoid "a downgrade in its rating that would force it to re-price all of the bonds that it insures." How do you reconcile these differences? Also, won't there be a severe impact on bondholders of state and county housing revenue bonds, as a result of the current situation?
S.G., Florida
Dr. Abrams responds: The article you refer to reflected the thinking of the rating agencies regarding the major bond insurers' subprime exposure. Since that time, the bond raters have had a change of heart.
The rating agencies use a "bottom up" analysis in order to arrive at a rating opinion. The specialists at each rating agency have adjusted their criteria and expectations regarding potential defaults in the mortgage backed securities sector. As a result, they have raised the "bar" for the bond insurers on the capital levels needed to handle potential default exposures.
While the bond insurers were previously in compliance with rating agency capital requirements, those requirements are now higher, leaving a number of insurers, including MBIA, below the level demanded by Standard & Poor's and Moody's.
Bond insurers are now in the process of seeking additional outside capital to satisfy rating agency demands. While we have no "inside" knowledge of their progress, we would be surprised if they were not successful in gaining the capital needed to maintain both their ratings and business future.
Remember, bond insurers, especially those rated "AAA", insure issuers who generally have investment grade ratings on their own. As a result, bond insurance for these issuers serves more as a means to lower interest rates than actually "credit enhance" their ability to make debt service payments. Virtually all of the bonds MBIA insures are making payments on their own, without relying on MBIA. Finally, while a downgrade of MBIA could cause a re-pricing of bonds carrying their insurance, we always encourage bondholders to purchase municipals for the income stream they provide, not capital gains.
01/14/08
Florida and the current market
I believe that I currently have a significant portion of my inheritance with FMSbonds, Inc. I would like your input as to what effect the subprime mortgage deflation will have on Florida’s economy and the muni market. Newspapers are reporting large withdrawals from municipal bond funds. What types of municipal products do you offer? Will your products experience the same volatility and over what duration?
D.P., New Jersey
Mr. Klotz responds: The potential damage to the Florida economy stemming from the subprime mortgage crisis is very difficult to gauge, but we don't anticipate any meaningful impact on the municipal bond market.
To date, there is no indication of a widespread problem in commercial money market funds, despite the highly-publicized reports of a few funds being in danger of "breaking the buck." Barron's recently also suggested that money market concerns are overblown.
As you mentioned, there has been increased volatility in the municipal bond market, caused for the most part, by the financial problems of the large brokerage firms and banking institutions that are no longer supporting the market due to their own capital issues.
The upshot is municipal bonds are providing unusually high returns when compared with other high quality fixed income investments.
01/14/08
Impact of deflation
What would be the impact on munis in the event the U.S. encountered a period of deflation?
A.G., Florida
Mr. Klotz responds: As you might guess, there is no simple answer to your question. With deflation, it depends on how much and for how long.
In general, deflation, in contrast to inflation, causes interest rates to drop and bond prices to rise. However, if deflation persists for a great length of time, problems could present themselves for weaker credits.
Severe deflationary periods are characterized by declining corporate profits, shrinking employment, reduced incomes, and increasing defaults on loans by companies and individuals.
In this type of worst-case deflation scenario, some municipal bonds might experience difficulty in servicing their debt. Fortunately, since the 1930s, the Federal Reserve banking system has developed a number of monetary tools to inflate the economy and avert deflation's negative consequences.
01/14/08 Davis case and pre-emptive moves
I am just learning about Davis v. Kentucky. While I do hold some stocks, most of my portfolio (probably over $150,000) is tied up in Ohio munis. In the Bond Forum answer (“Davis and California tax-free fund”), you told an investor he can "painlessly switch to the federal tax-free bond fund within the same family of funds. According to the sponsor, this fund has a similar yield and has minimal AMT exposure." Is that also an option for me? What is your opinion on Kentucky v. Davis? My financial advisor told me that if the Kentucky state court decision is upheld by the U.S. Supreme Court, it would “hurt" but not “kill” me. I’m not sure what that means and I am getting a new advisor.
J.A., Ohio
Mr. Klotz responds: A U.S. Supreme Court ruling in favor of Kentucky would mean a reversal of the Kentucky Supreme Court finding that taxing out-of-state bonds is unconstitutional.
We said that switching from a California bond fund would be "painless" for the investors in question because they are residents of the state of Washington, which has no state income tax. Your case is different, since as an Ohio resident you would be required to pay tax on the out-of-state income produced by a national fund.
If the Supreme Court rules against Kentucky, your advisor might be correct regarding a potential market value decline in your holdings, but it should have no effect on your dividends. Since individual bonds can be held to maturity, the market value impact would be less significant.
Once again, we don't recommend any pre-emptive moves. We don't expect the U.S. Supreme Court to uphold the decision, and if it did, the mutual funds themselves would be forced to make the appropriate adjustments since there would no longer be a need for state-specific funds. We still believe the odds of this occurring are slight and certainly not worth losing sleep over.
01/14/08
What happens to munis if insurer defaults?
If a bond insurer defaults, what happens to its portfolio of insured munis? Is the future revenue stream of insurance premiums still intact, which could then be assumed by a successor insurer like FSA? Or do the bonds simply lose their insurance, even though all future premiums were prepaid at issue, and remain bare until maturity? I know you feel that the chances of insurer defaults are remote, but their collapsing stock price, combined with “short to float” ratios over 30% and skyrocketing CDSs suggest otherwise.
M.G., California
Mr. Klotz responds: Although we believe it unlikely, a bankruptcy by one of the major bond insurers would have less impact on municipal bond investors than one might think.
Today, bond insurers are paying interest on less than .1% of all insured bonds.
One reason insuring municipal bonds has been so profitable for these companies is that for the most part, they only insure issues that don't need insurance. Most insured bonds enjoy strong credit characteristics on their own merit.
Ironically, the insurance companies' problems have come from the CDO market, not from their portfolios of tax-free bonds. Municipal bonds are traditionally considered second in safety only to U.S. Treasuries.
Bond insurance has proliferated over the past 30 years because it allows municipalities to borrow at lower rates, and adds an extra layer of protection for the investor.
Even though "up-front" premiums are amortized over the life of the bond issue, it is unclear what the result would be in a bankruptcy or reorganization procedure.
Bondholders should not lose sight of the fact it is the issuer, not the insurance company, that is paying them principal and interest, and will continue to do so for the vast majority of insured bonds in the marketplace.
01/14/08
Davis and California tax-free fund
We have $150,000 invested in a California tax-free income fund. All dividends and capital gains are reinvested at this time. Should we be concerned with this Kentucky decision or the AMT? We live in the state of Washington.
D.S., Washington
Mr. Klotz responds: We are not sure why, as residents of Washington, you are invested in a California state fund, since Washington has no income tax.
If you are concerned about the ramifications of the Davis case, you can painlessly switch to the federal tax-free bond fund within the same family of funds. According to the sponsor, this fund has a similar yield and has minimal AMT exposure.
12/28/07
Would Davis be retroactive?
Does Davis v. Kentucky represent a taxing strategy that can be applied retroactively, or from the present forward? How can a new tax law be applied retroactively – doesn’t the terms of a bond (including tax-free status) represent a contract between bond holder and bond issuer?
D.D., California
Mr. Klotz responds: There has been no discussion about making the tax retroactive. In fact, if the Supreme Court decides that taxing out-of-state bonds is unconstitutional, it would probably trigger a number of investor lawsuits to recover back taxes.
You are correct. The trust indenture outlining the terms of a bond represents a contract between the bondholder and the issuer; however, there is no mention of state tax exemption in this agreement.
We don’t think the U.S. Supreme Court will agree with the Kentucky decision, though if it does, the current law exempting California bond interest from taxation will have to change. Under this scenario, the state would have to decide if it will stop taxing interest from out-of-state bonds or tax California bond interest, too. In this case, no tax-free interest would be exempt from state tax.
Once again, we think the court will overturn the Kentucky court decision and maintain the status quo.
12/28/07
Interest on reinvested tax-free dividends
My mother-in-law has some tax-free closed-end bond funds that were dividend reinvested since the late ‘80s and ‘90s. Since the dividends were tax free and reinvested, do they increase the basis of the original investment or must they be considered capital gains in the event of a sale?
M.M.
Mr. Klotz responds: The reinvested interest will increase the cost basis. It is not a capital gain.
12/28/07
Hedge against inflation?
I own $2.5 million of long-term muni bonds and would like to protect the purchasing power of the income I am receiving. What instrument can I buy that will increase in price as interest rate goes up? Will buying put options of a municipal bonds fund be a good idea?
E.L.
Mr. Klotz responds: We have never discovered a realistic hedge against inflation for municipal bond portfolios.
Investing in Treasury Inflation Protected Securities (TIPS) or buying puts on closed-end muni funds, as you suggest, requires sacrificing too much income.
Remember, income is the reason you bought your bonds in the first place.
Tax-free bonds are a long-term investment. It is our experience that you will be better served by riding out any periods of higher interest rates since the Federal Reserve's mandate is to take the necessary steps to keep inflation under control. This policy invariably leads to lower inflation and, in turn, lower interest rates.
12/28/07
ACA
Do you still have a positive look on ACA in light of its recent troubles? Seems that people will be dumping ACA insured bonds.
J.W.
Mr. Klotz responds: If you review our articles, you will find we have never been overly enamored of ACA. We have, however, had good things to say regarding the underlying credits of many of the issues ACA insures, and we continue to. We would be pleased to provide our opinion on any ACA insured bonds you hold.
12/28/07
Focus on maximizing income regardless of age
You have made a case against laddering, but did you ever consider that some of us are retired and need this income to live on? We can’t reinvest the income of these bonds as you showed in your examples. What do you suggest to the people in their 70s and over who need more income? We need to preserve our principal in order to continue investing it.
A.L., Florida
Mr. Klotz responds: We always take this into consideration since a substantial number of our clients are retired and living on their tax-free income. They buy long-term bonds and collect 35% to 50% more income than they would with a short-term laddered portfolio.
Actually, we were a bit surprised by your question. If you have employed a laddering strategy in the past, you have experienced the double whammy of initially sacrificing income, and then being forced to reinvest your principal at lower rates as bonds come due.
If you are currently able to live on the income from your laddered portfolio, you can reinvest the additional income thrown off by long-term bonds. (Example: 5.00% as opposed to 3.50%.)
Remember, over the life of a long-term bond, it will sometimes be worth more than you paid for it, and sometimes less. What's the difference? Enjoy the income! Your bonds will either be called or mature at full value.
12/5/07
The “s” in insurers’ acronyms
Can you explain why some territorial paper from Guam, Puerto Rico, etc. is listed as being insured by SMBIA, SFSA, SCIFS, etc? Are they the same as MBIA, FSA, etc.?
B.F., New Hampshire
Mr. Klotz responds: Yes, these are the same insurers and the same coverage. The "s" prefix denotes that these securities were insured in the secondary market, not at issuance.
12/5/07
You say, "Bond Insurers are only compelled to pay principal and interest if the underlying borrower cannot do so." Does this mean that the insurer is obligated to pay to the bondholder the future interest stream on the defaulted bond as well as the principal at term in the same manner as the original borrower? Or does this mean that the insurer is only obligated to pay to the bondholder the principal at the time of default? In other words, the bondholder is guaranteed only the return of his principal and will forego the future interest stream of the original bond.
C.E., California
Mr. Klotz responds: Actually, the insurer has the option to pay off the entire debt at the time of default or to maintain the terms of the original bond indenture (interest and principal). The latter is almost invariably the preferred approach.
The reasons for this are obvious. Often, the issuers' problems are short-term in nature and remedies can be implemented to correct the shortfalls. In this scenario, the issuer, at some point, resumes its payments of principal and interest. The issuer is further obligated to reimburse the insurance company for payments made during the period the issuer was unable to do so.
12/5/07
* * *
Your article did little to put my mind at ease. First, you repeatedly referenced AAA-rated bonds, but what about lesser grades, although higher than BBB? Seems you're hedging your comments. And my understanding is that some of these bonds only get the AAA rating because of the insurance, so the underlying rating is less than that. Second, you say MBIA reports that it incurred losses on only 102 transactions of 93,211 issues in its 30-year history. That’s about one loss in every 900 issues. Seems relative high to me, given that the entry rating to get insurance is - as you say - an investment grade BBB. Third, in the last 30 years (or longer) we have never been in a financial climate like we are now. You are obligated to try and ease the concerns of your investors, but you are in an unenviable position of having a serious conflict of interest in trying to persuade us that all is well. I can’t sleep any better based on what you are telling us.
D.W., California
Mr. Klotz responds: We did not intend to hedge our comments regarding bond insurers and the high degree of safety provided by municipal bonds, insured or not. We should have made it clear that we were addressing a specific customer inquiry regarding the potential impact of a downgrade by Fitch of one of the AAA insurers.
Our point is, the vast majority of insured issues are adequately secured on their own merit, and the fact they are insured provides an additional level of credit enhancement, which rarely comes into play.
I agree that we are experiencing an unusual financial climate, but hardly find it to be the dire situation described daily by sensationalist financial journalists.
The stock market, although down recently, is still hovering in the 13,000 area. Long-term interest rates are very low and employment statistics continue to be excellent. The current "crisis," although serious, is pretty much confined to the housing and mortgage market, which was badly in need of a correction.
I don't find myself to be in an unenviable position, as you describe, since I sincerely believe in the security provided by municipal bonds, which comprise the majority of my personal net worth.
12/5/07
* * *
Good comment and to the point.
S.F., Florida
Bond safety and the subprime mess
How does the subprime problem affect municipal bonds? Will there be a recession? I personally would be wiped out financially if the municipal bond market failed. What are the real risks in municipal bonds?
D.S.
Mr. Klotz responds: We don't see the subprime problem having any adverse impact on the credit quality of municipal bonds. Typically, bond holdings appreciate in value during a recession. Slower growth leads to reduced demand for money and ultimately lower interest rates.
Municipal bonds as a class of securities are considered to be second only to Treasury bonds in regard to safety.
12/5/07
* * *
I am 80 years old and have quite a few municipal bonds. What happens to these bonds in a recession or depression? I understand that there are tax-free money market-like bonds that mature weekly but can be rolled over until cash is needed. Is this true? If so, how does one buy them, and what does it cost to buy & sell them?
D.D., Maryland
Mr. Klotz responds: We have been involved with the municipal bond market for over 35 years and have seen a number of recessions during this period. These recessions had virtually no impact on the high quality, tax-exempt bonds that you purchase.
We think you are describing what are called "floaters." They are a type of mutual fund created by brokerage firms that provide higher short-term returns than available on money market funds.
They differ from money market funds because of restrictions governing the redemption of shares. We don't recommend floaters as an alternative to bonds since they provide no call protection.
12/5/07
Suppose the Supreme Court rules against Kentucky in the Davis tax case. I have California tax-exempt bond funds and I'm concerned. How much revenue would California forgo if it exempted all bonds from tax to be able to continue to exempt their own, and wouldn't exempting all bonds make California's worth less than they are now? It would seem that since national tax-exempt funds have higher NAV, higher yields and are paying a higher distribution yield than state-specific funds now, state-specific funds would only decline further in value compared to the national funds when state-specific funds lose the distinction of being tax free for the residents of their states and become the same as the bonds from all other states. I think it may be a good idea to transfer out of California bonds into national tax-exempt fund.
R.O., California
Mr. Klotz responds: Right or wrong, we believe the Supreme Court will politicize its decision and rule in favor of Kentucky, but there’s no guarantee it will.
If Davis v. Kentucky is reversed, our guess is that high income tax states with budgetary issues, such as California, will tax the interest from their own issues rather than sacrificing the revenue collected by taxing out-of-state bonds. If this occurs, we agree with your observation that California issues will adjust to the national market, since California residents will be able to look elsewhere for higher yields. Curiously, it might also have the effect of lifting the value of bonds issued in low or no tax states, as the market seeks equilibrium.
The decision to transfer from your California holdings is a tricky one in light of the fact the Supreme Court has indicated that they were leaning toward Kentucky's argument.
It's really a tough call. Executing a transfer in advance of the Supreme Court decision could prove to be costly.
12/5/07
It appears to me that the rating agencies are quite fickle since S&P has made a 180-degree turn and put ACA on negative credit watch with the possibility of a downgrade. ACA just had over a $1 billion write down. In the event of a downgrade below A, it is my understanding that they would have to come up with more than $1 billion in cash. Looking at the stock performance, it is my view that the investing public did not have a great deal of confidence in S&P's rating view. After all, these are the same rating agencies that rated many Collateralized Debt Obligation (CDO) tranches AAA and have downgraded them several times in a relatively short period of time. Since the issuer pays the rating agency a fee, an inherent conflict of interest seems to exist. Congress and the regulators are just now starting to review this situation, since the public's confidence in these rating agencies has waned. Beyond quoting S&P's analysis, what is your internal analyst's independent view on ACA and what remedies does ACA have now?
B.P., New Jersey
Dr. Abrams responds: ACA's public finance business remains fundamentally sound, with capital and claims paying resources in excess of that required by S&P for an A-rated insurer. We have reviewed ACA's portfolio of insured credits that FMSbonds has sold, and they are performing well, paying debt service on time. The CDO exposure that ACA carries on its books should not result in any monetary loss, so long as the CDOs mature in full, which ACA expects they will.
ACA will meet with Standard & Poor's and try to resolve the rating agency's concerns. Regardless of the outcome, ACA's insured issuers continue to meet their obligations to bondholders in a timely manner. It is too early to speculate on the outcome of ACA's discussions with S&P, but the rating agency has come away satisfied in past situations in which ACA's strength was called into question.
11/19/07
* * *
If Fitch downgrades the bond insurers, how can there not be a large selloff of insured municipals? How do you expect the muni market to react to the bond insurers being downgraded?
C.
Mr. Klotz responds: In your e-mail, you cite an article from the Lyndon LaRouche Political Action Committee. Our first thought is that you should find a more credible source for information regarding the municipal bond market.
The article attributes sensational comments to "one municipal bond market advisor," which we consider to be reckless and irresponsible.
As we state in our most recent commentary: "Bond insurers are only compelled to pay principal and interest if the underlying borrower cannot do so. Remember, issuers in the municipal bond market almost invariably meet their payment obligations."
Why then, would the downgrade of a AAA-insurer be a "crushing blow" to the municipal bond market, as the article states?
During this turbulent period, you may not want to hold a bond insurer's stock, but the bonds will be fine.
11/19/07
* * *
In your article, you mention that rated bonds are relatively safe. My question is, why would FMSbonds choose to underwrite projects in which the bonds were unrated, such as the Anthem Park issue? Can a buyer of such a bond obtain insurance on his own to get some "peace of mind?
J.R.
Mr. Klotz responds: Although we have traded the Anthem Park bonds you mentioned in your e-mail, this issue was not underwritten by FMSbonds, Inc. Our firm, however, is very careful when it comes to evaluating bonds we recommend to our clients, especially those with no credit rating.
In this case, Anthem Park is a new residential community under construction by D.R. Horton outside of Orlando, Florida. In addition to having a developer/builder that is one of America's largest, Anthem Park's bonds are secured by special assessment fees collected simultaneously with property taxes.
Anthem Park did not apply for a rating at the time of issuance because it was a new project. Rating agencies prefer to see a district mature with significant buildout before issuing investment grade ratings. Several districts in Florida, similar to Anthem Park, have obtained investment grade ratings once buildout has occurred.
At one time, individual portfolio insurance was made available by some of the bond insurers. To the best of our knowledge, they have discontinued this practice.
11/19/07
* * *
I'm sure your read the recent Dow Jones article that suggests we are overpaying for insured munis and may actually get a higher yield, with no more risk, on A or better-rated paper that is not insured. The article also advises muni buyers to focus on the underlying rating of an insured bond and avoid them if they are not A rated or better. Most bond brokers never mention the underlying rating unless asked and emphasize that the AAA rating of an insured bond is mostly what matters. How do you feel about this in light of the recent events in the bond insurer arena?
S.F., Connecticut
Mr. Klotz responds: : Excellent question. Please click here for a complete discussion of this issue.
11/19/07
Step-up CDs
My wife and I have $2 million invested in various forms of fixed income. What do you think of step-up CDs and corporate notes? We are looking at Toyota with a term of 20 years. The rate of 8.56% is guaranteed for the first year. Our goal is to realize as much income as possible while alive and protect the principle that will be left to our heirs when we die. The survivor option is a plus. A major risk that I see is a negative yield curve. Is there something additional that should be considered?
J.C.
Mr. Klotz responds: Since your objective is maximizing income for an extended period of time, you may be under-emphasizing the importance of the lack of call protection with step-up CDs and the Toyota issue you mentioned. (By the way, we don't see the new Toyota 8.625% issue having a survivor's option.)
The problem we see with both classes of securities is that your bonds or step-up CDs will be called precisely when you don't want them to be – when rates are lower and reinvestment at a comparable rate is not possible.
If your tax bracket is not a consideration, we would suggest a corporate bond with adequate call protection to guarantee your income for a reasonable period of time.
11/19/07
Dividends if the NAV drops
If I buy $1 million worth of a tax-free bond fund shares (say, 133,333.33 shares at $15.00 per share) that is paying a monthly dividend of 5% ($4,166), and next month the NAV drops to $14.50 per share, will I continue to receive dividends of 5% of $1 million ($50,000)? What happens if the NAV increases to $15.50 per share? Can I sell the NAV profit and continue to receive the original 5% of $1 million, the original purchase price?
P.S
Mr. Klotz responds: Let's start with the arithmetic: A $1 million investment in the hypothetical bond fund you describe at $15.00 per share would result in you owning $66,666.66 shares.
Bond funds pay dividends on a per share basis (in your example .75 equals $50,000.00 annual income or 5.00%). This dividend remains constant unless it is cut or raised by the mutual fund.
If the dividend has not changed, a reduction in the NAV would not affect your annual income, since you will continue to own the same number of shares paying at the same rate. This would also be true if the NAV increased because you would likewise be receiving your dividend based on the same number of shares.
If you decided to take your profit by selling the appropriate number of shares to reduce your investment to the original $1 million, your annual income would be reduced proportionately since the dividend per share would now be paid on fewer shares.
In this example, if the shares appreciated to $15.50, your original investment would be worth $1,033,333.25. To take your profit and reduce your investment to the original $1 million would require selling 2,150.53 shares. Since you would then own 64,516.66 shares, this reduction in shares would cause your annual income to drop to approximately $48,387.50 (.75 x 64,516.66).
11/19/07
Showing income to the IRS
I have a question re subject bonds. I know they are tax free, but do you have to show income to the IRS when you file your returns?
P.S., New Jersey
Mr. Klotz responds: The federal government requires this information be reported by the investor as well as the institution holding the bonds.
11/19/07
Advantages of premium bonds
When I look for munis maturing in four or five years, the yield to maturity these days for AA or better is around 3.4% to 3.5%. However, I frequently see a YTM of 3.6% to 3.7%, where the only apparent difference from the surrounding bonds is that the higher yielding bond is actually a longer term bond that is pre-refunded (sometimes to 101 or 102, for example) to the earlier date four or five years from now. There are plenty of examples of this. Why should the market assign a higher yield to a pre-refunded bond with exactly the same rating as the bonds around it? I buy these pre-refunds all the time, but have never understood why they are the bargains they appear to be. Am I missing something?
D.M.
Mr. Klotz responds: Your observation is not only correct, but can be taken a step further.
Since pre-refunded bonds are typically escrowed in U.S. Treasuries, they are of higher credit quality than any of the other AAA bonds surrounding them.
The yield anomaly you describe is really a function of merchandising rather than bond fundamentals.
Individual investors are too often averse to buying bonds which trade above 100.00. Pre-refunded bonds, by virtue of their larger coupons, produce higher dollar prices (premiums). Bond dealers must offer these bonds with higher yields simply to be able to sell them.
You, however, understand that the only way to determine the value of your bond investment is yield, regardless of the dollar price, and furthermore, that every dollar invested (including premium dollars) is working at the stated yields.
As a reader of our Bond Forum, you are aware that we always have, and continue to, recommend premium bonds to our clients precisely for this yield advantage.
10/31/07
Where you live affects what you buy
I am considering investing up to $6 million in tax-free municipal bonds. I currently live in Michigan. My concern is that the government, both federal and state, will not stop spending and therefore will continue to increase taxes. I am interested in short-term municipal bonds (I am concerned about a future increase in interest rates and want to preserve principal) that are exempt from federal, state, local and alternative minimum taxes. I am also considering moving to Florida. Can you help?
D.H., Michigan
Mr. Klotz responds: We have helped individual investors achieve their investment objectives for almost 30 years, and we would be pleased to assist you in this regard.
The approach to building your bond portfolio would be considerably different as a Florida resident than if you remained in Michigan. Currently, a Michigan investor, because of state income taxes, is compelled to purchase bonds issued within the state or U.S. territories. A Florida resident, however, has no such geographical restrictions.
We would recommend speaking with one of our bond specialists to discuss your various options in greater detail.
10/31/07
Creditworthiness of tobacco bonds
Do you know the creditworthiness of various state tobacco bonds, and which ones, from a risk/return standpoint, offer the best relative value? Also, I am a Massachusetts resident, so could you provide any information on the tobacco bonds of Massachusetts?
G.G., Massachusetts
Dr. Abrams responds: Massachusetts has not issued tobacco bonds and, as far as we know, has no plans to do so.
In response to any question regarding relative value, we point to the credit underpinnings of these bonds. Tobacco bonds, as a class, are secured by payments made under the Master Settlement Agreement to participating states and territories. The amount each state receives each year is based on a pre-determined formula that is applied against the total dollar payment received from the tobacco industry. This payout each year is based upon domestic shipments of cigarettes.
Treated as a class, tobacco bonds carry credit ratings based generally on the rating agencies’ assessments of the credit quality of the tobacco industry.
The same projections of smoking trends and their effect on MSA payments are used for each bond issue. Distinguishing characteristics between tobacco bond issues are few, but can encompass annual coverage projections and some aspects of structuring. Overall, these issues are structured similarly and are generally rated in the BBB/BB rating categories.
We do not have separate research available on relative value, but a search of our Web site will provide numerous commentaries on the benefits and challenges presented by this category of securities. You may also want to contact the rating agencies for any reports they have issued.
10/31/07
Land-secured bonds
I am taking a tax/investment real estate class at the moment and one of the students posted a comment on our discussion board talking about land bonds. I have never heard of a land bond before.
T.W
Mr. Klotz responds: Municipal bonds are sometimes issued in the pre-construction phase of a single-family housing development. In the industry, they are often called "land secured" or "dirt" bonds. They are referred to as such because, initially, they are secured by a tax or assessment on the undeveloped property.
10/31/07
ACA rating affirmed
With the current illiquidity in the market for ACA insured bonds it seems to me that their ability to write new municipal bond business is going to be severely hampered. I would also assume that any new Collateralized Debt Obligation (CDO) business is dead. How can they survive under these conditions? Where are the revenues going to come from?
B.P., New Jersey
Mr. Klotz responds: ACA's CDO exposure and general business mix have been reviewed by Standard & Poor's and its rating has been affirmed. Market liquidity varies over time, and we're now seeing a resurgence in paper insured by Radian Asset Assurance, a AA-rated insurer that has a similar niche to ACA. This may presage a similar rebound for ACA as well.
The capital markets are fickle and current conditions are challenging, no doubt. However, ACA has a sound business strategy and capital position in the eyes of S&P and there will always be infrequent issuers of municipal bonds whose size and specialized projects will be a good fit for ACA's underwriting approach. While financial firms large and small have been reporting mixed results as of late, we anticipate that ACA will perform in a similar fashion as the rest of its peers.
10/31/07
Stung by fees
I’d like to know what the common fee structure is when it comes to paying a broker to purchase municipal bonds. I just found your site and am not sure yet, but I may be able to buy bonds from your firm. Currently, I have about $1 million invested in muni bonds in the state of Ohio and pay a financial adviser to manage all my brokerage funds. If I had these funds in different stocks and mutual funds and was moving them around, I could agree with his fee structure. I am struggling with the fact that the majority of my investments are locked into long-term (7-10 years), low-risk bonds and I am paying his fees. With an approximate 5% return per year, I am paying almost .75% of that to the broker year after year in fees. In the next several years, I will have approximately $2 million more to invest in muni bonds. Is there a lower fee option?
P.F., Ohio
Mr. Klotz responds: We are not proponents of professional management for municipal bonds.
Our 30 years of experience buying and selling tax-free bonds has taught us that individuals do not need a "bond manager" to build a bond portfolio that provides safety and a steady stream of tax-free income. In fact, we have never seen a managed bond account or bond mutual fund that, after accounting for fees and costs, has produced better results than simply buying and holding individual municipal bonds.
Like other brokerage firms, FMSbonds is in business to earn a profit. But we differ in our approach. We do not think you need us, or anyone else, to "manage" your bonds. Our approach is quite basic. We assist you with purchasing quality bonds that provide excellent tax-equivalent returns. Then we advise you to leave them alone. An individual continually buying and selling bonds in his portfolio is doing himself a disservice. This is what bond managers do. There may be situations that dictate selling a bond, but they are rare and should be based on common sense reasons that are easily understood by the investor.
Although a charge of .75% to manage your bonds may not appear significant, it becomes substantial in the context of a security that returns 5.00%. (.75% represents 15% of the income on a 5.00% bond)
As municipal bond dealers, we do not charge a commission. We make our money by buying bonds on the bid side of the market and selling to our clients on the offering side. All prices on our Web site are net to the investor. There are no additional fees or charges.
We also offer free safekeeping and custodial services at the Bank of New York, where our customer accounts are insured up to $25 million.
9/19/07
I am following the AMT situation closely because my husband and I are getting more burdened with it every year. Even in retirement, it gets worse. We were hoping for some relief by a one-time fix in 2007. Did you get a sense that this will happen before the end of the year?
M.S., Virginia
Dr. Abrams responds: While Rep. Charles Rangel, chairman of the House Ways and Means Committee, indicates he is not interested in a one-time fix for the AMT this year, it is very hard to believe that anything else will occur until after the 2008 election. The votes for AMT reform are there, but there is no consensus as to how the revenues generated by the AMT would be replaced. I think Rangel will use this year's debate as a means to test various revenue raising proposals.
What this likely means is that a one-year patch will be passed again since Congress will not want to face angry voters in 2008. Rather, should the Democrats increase their majority and win the presidency, overall reform would be addressed at that time with a better chance of passing. Of course, we have no way of actually knowing how Congress will deal with this issue this year, but this is what we see as the most likely scenario.
9/19/07
* * *
Are they trying to cheat the poor people again? How will this affect the average muni bondholder?
J.P., Florida
Dr. Abrams responds: Investors need to consult with their tax advisor to determine how the AMT is likely to affect their tax liability. Bondholders whose holdings are strictly non-AMT would not count interest earned on those bonds in their AMT calculation. Since tax-exempt bondholders are comprised of individuals with varying financial backgrounds and diverse portfolios, it is not possible for us to address the effect of AMT reform on the "average" bondholder. Your tax advisor/accountant will be able to assist you in analyzing your portfolio and recommending a tax and investment strategy tailored to your needs and situation.
9/19/07
Reliability of tobacco bonds
I found your offering of a “tobacco securitization settlement bond” interesting. Can you tell me what it is? In the past, I've purchased AAA, insured tax-free munis. What is the difference in quality (i.e. reliability) between what I've owned and the tobacco bonds? Are tobacco bonds insured or insurable?
L.R., California
Dr. Abrams responds: In 1998, the nation’s largest tobacco makers agreed to pay 46 states and four territories a total of about $200 billion over 25 years to settle states’ legal claims against the companies. The disbursements are made yearly and are based on the number of cigarettes shipped domestically for that year.
In order to gain access to these funds up front, many states “securitized,” or issued bonds, against these payments. In turn, annual payments by the tobacco companies go to bondholders instead of the states. Currently, about $20 billion in tobacco securitization bonds are outstanding.
Many investors favor tobacco bonds because of their outstanding yields. Additionally, lawsuits challenging both tobacco companies and the agreement with the states have declined, and the legal environment has been viewed as more benign by bond investors.
If you search our Web site for “tobacco bonds,” you will see many articles on developments affecting these bonds.
The tobacco securitization bonds are mostly rated in the “BBB” and “BB” categories by the rating agencies. At this point, none appear to be insured.
9/19/07
What’s up with the market?
We have a family trust that is 100% invested in New Jersey municipal bonds, with a face amount of $1 million. The current market value of the bonds is way down and is fluctuating between $965,000 and $975,000. I am trying to understand the market conditions that are responsible for this, and my inquiries to our ML broker are not providing me with anything that I can readily understand or explain to my father.
R.K., New Jersey
Mr. Klotz responds: You are not alone. Many other investors are seeking perspective on the recent activity in the municipal bond market.
Please carefully review this page, the Bond Forum, where we address many similar questions. Additionally, see “The Reality Behind the Bond Shakeup,” where our head trader, Terry O'Grady, discusses why bond prices have been impacted by the unwinding of tender-option bond programs.
9/19/07
Thank you
Congratulations. You are without a doubt the most advanced company in the marketplace today for people in the municipal bond market. Your efforts are appreciated.
B.Z., New York
In light of the subprime mortgage problems, what would happen if an insurer were to go bankrupt? Is it like other insurance, where there are insurance pools that would step in and take over?
D.W., California
Dr. Abrams responds: Keep in mind that bond insurers remain strong. S&P recently published a technical article that analyzed the impact of an unlikely high-stress scenario resulting from the insurers' exposure to subprime mortgages. In all cases, it was found that the insurers could easily handle a level of defaults far beyond that rationally expected.
Clearly, the subprime mess is taking its toll on financial institutions everywhere. However, the largest stress is due to the need to re-price mortgage based securities downward because of market imbalances. The increased default rates of subprime mortgages have been far exceeded by their drop in price. This, in turn, has required many lenders to post increased collateral since they are highly leveraged. In the bond insurance business, the impact has been different. Bond insurers are not required to post collateral like other financial institutions. And, bond insurers generally hold securities on their books to maturity when they will be worth par.
While we consider an insurer’s bankruptcy as highly remote, the chances are that the rest of the bond insurance industry would most likely step in to provide a remedy. There are no formal "insurance pools" in existence for this purpose, to the best of our knowledge. But it is likely that the rest of the industry would do whatever was in its power to avoid such a calamity in order to prevent a loss of confidence in bond insurance in general. This could mean a takeover of the defaulting insurer's business by a stronger entity, or assembling a pool similar to what you mentioned.
We would expect that an insurer in trouble would never get close to a default, since the above steps would be taken far in advance. Remember, too, that state regulators would take a strong interest in such a situation and would likely use their powers and authority to seek a solution.
Of course, all of the above is speculation only. In the few cases that do exist of bond insurers losing their credit rating, they were all absorbed by other players in the industry and investors were never in harm's way. I hope this helps.
8/17/07
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I am deeply concerned about what’s going on in the market. I find it hard to believe that “the bond insurers have mostly insured only the mid to higher levels of CDOs,” as you say, since it’s become clear that most holders of CDOs don’t really understand the risk profile. Furthermore, you say “a large segment of the CDOs would need to be in default before the insured layers would be impacted. This is not anticipated.” Well, I don’t think any of the experts anticipated we’d be in the turmoil we’re experiencing today, so I’m not convinced their judgment is credible. I, too, am concerned about what would happen to the insurers if we truly had a meltdown. I’ve never understood how the insurers could cover the potential calamity that could arrive. How could insurers protect us in a crisis?
A.S., New Jersey
Dr. Abrams responds: First, the bond insurers have all published data on their exposures to the CDO market. This data has been thoroughly analyzed by Standard & Poor's analysts who specialize in structured finance, including the underlying credits that have been "rolled up" into CDOs. Based on historical and worst-case scenarios, these analysts then apply such cases to the cash flows furnished by the underwriters to determine the impact of a high level of defaults of underlying subprime loans on the ability of a CDO to meet its payment obligations. It was based on this analysis that S&P and the other rating agencies took recent rating actions.
The fact is, bond insurers have generally insured the middle to upper levels of CDOs, and are, therefore, limited in the exposure they have to a CDO with problems. ACA, for instance, has published a list of the CDOs it has insured and the "attachment points" (or point exposure begins) at which their insurance kicks in. Clearly, if the entire, or substantially most of a CDO defaults, the insurer would be on the hook to make up the shortfall and this could be costly. However, the analysis by S&P referred to above indicates this to be highly unlikely. Unlike news reporters who base their analysis on cursory analysis, rating agency analysts do their homework using all of the analytical tools available to arrive at their conclusions.
Second, much of the news we read makes it sound like everyone with a subprime mortgage loan has stopped paying and is in default. This, of course, is patently false. Yes, default rates on such loans have climbed, but not stratospherically. If it had, we would see collateral indicators, such as high unemployment, sharply increasing defaults on consumer debt and car loans. Yet, this has not happened to any significant extent. So, we do not believe a "meltdown" is imminent. The data does not support the economic calamity scenario.
Finally, many of the financial institutions experiencing severe difficulties are doing so not because of mortgage payment defaults, but because of the need to "mark to market" the mortgage backed securities they hold. This means they have had to re-price severely downward the value of these securities because of the market reaction to the subprime sector. As a result, many have had to meet margin or collateral calls which some have had difficulty doing. This point is important: municipal bond insurers also need to mark to market those securities maintained on their books, but do not have to meet margin calls like other types of financial institutions. So, thanks to today's accounting rules, bond insurers can have a portfolio of mortgage loans that are performing credit-wise, but must record losses to indicate decreased market value. Since most of these securities will be retained until maturity, it is unlikely they would actually suffer a loss.
We too are concerned about the impact of the CDO and subprime crisis on the bond insurers. We do rely on them to provide publicly disclosed information upon which we base our opinions. If such information is incomplete or incorrect, we might react differently. That being said, we closely monitor their financial condition and stay in contact with rating agencies and others to insure we react in a professionally appropriate manner. If our opinion should change, we will certainly let our clients know.
8/17/07
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How will the potential hedging of the tender-option-bond-programs, or unraveling of these trades, affect the value of AAA-rated insured bonds? Will this seriously harm bond values and is it a transitory effect?
D.M., New Jersey
Mr. Klotz responds: Yes, high-grade bond prices have been impacted by the unwinding of some of these programs.
Tender-option-bond programs sell lower yielding short-term notes and invest in higher yielding long-term municipal bonds, pocketing the difference. These often highly leveraged programs are run by hedge funds and banks. They account for approximately $200 billion of municipal bond holdings.
Large hedge funds have been liquidating these long-terms bonds, putting pressure on all municipal bond prices.
To add insult to injury, the funds that had been big buyers of bonds in the past few years are no longer lending support to the market.
The good news is that these conditions, which should be transitory, are currently providing unique buying opportunities for high quality bond investors.
8/17/07
I’m having trouble following your logic. Would you make clearer what is happening to the markets?
D.J., New York
* * *
How do you determine which bonds that are at depressed levels? It seems to me that it would take a team of experts led by Bill Gross to determine the truth from the trash.
M.G., California
Terry O’Grady, Chief Bond Trader, responds: In a nutshell, there are a number of well-secured bonds that have been dropping in price due to the "herd mentality" that often accompanies panicky markets.
Some of these securities are not even remotely related to the sub-prime mortgage problem and are secured by independent revenue sources.
When markets tumble and institutional investors need to raise cash, those who can't find a market for what they would like to sell, sell what they can.
In the current case, it happens to be some good quality, investment-grade tax-free bonds.
One example is tobacco securitization bonds. B | 
