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Providing comfort in California

Referring to your article, "Putting California in its place," ,I agree with the view that California G.O. bonds offer an opportunity for capital gains, but I wonder if it isn't too soon to make this investment. It's my understanding that California G.O. Bonds maturing in the 2026 timeframe, with a coupon of 5%, are now priced between 95 and 97 -- yielding about 5.2%. I agree that the referendum is a diversion, except insofar as the winner, if other than Davis, has every incentive to get the state's problems out in the open and sooner rather than later. The state's financial problems are daunting. It already taxes its residents at an astronomical level, notwithstanding Warren Buffet's accurate but narrow comment on the property tax component, which is limited by Proposition 13.

It seems to me that your comparison with New York City in the 1970s is appropriate, but you fail to mention that the Municipal Assistance Corporation was created to discharge the city's obligations under bonds that were in (or about to go into) payment default. If we review the pricing of NYC G.O. Bonds at that time, I suspect we would see pricing on the order of 50-65 rather than the 95-97 we now see for California G.O. Bonds today. Doesn't this argue for waiting until the truly dire state of California's finances becomes evident and the market more appropriately prices the G.O.s?
J.C.
09/8/03

Mr. Klotz responds: We didn't suggest buying California bonds for capital gains. Our philosophy is to buy tax-free bonds for the income. When bonds appreciate enough to provide substantial capital gains, we rarely recommend selling, since taxes must be paid and similar income can rarely be replaced with bonds of comparable quality. The purpose of our article was to comfort California investors who hold these bonds as well as those contemplating a purchase.

We would not be surprised if California bonds declined further in price because, as you say, the state's financial problems are daunting, and we are also not enamored by California's leadership. We do, however, have faith in the fundamental structure of general obligation bonds and consider the possibility of default on this debt to be extremely remote.

Laddering comparison

Your article on laddering "Why laddering leaves you on the bottom rung" is interesting and I enjoyed your comparison. However, you didn't account for the income from portfolio #1 - it just went away - while the income from portfolio #2 was consistently used to purchase more bonds. If the income from #1 had been used, as in portfolio #2, to purchase additional bonds, the results of the two portfolios would have been much closer, no?
T.H., Nevada
9/8/03

Mr. Klotz responds: If we had done what you suggested, it would not have been a fair comparison. Although it may have been a bit difficult to follow, if you re-read the article, you will see that the only income used for reinvestment was the ADDITIONAL income generated by the long-term, unladdered portfolio. That is fair, and is the compelling reason that we recommend that investors buy longer-term bonds and maximize income on each purchase.

Radian ratings

I recently bought some NC HOSP REV MARIA PARHAM MED bonds, but I have to admit I was hesitant. I looked up these bonds and found that they were rated BBB- at time of issue. This is only one level above junk status. I assume they are now rated AA because they are Radian insured. But Radian is not as financially as strong as MBIA or AMBAC. So I see two levels of risk here, one the original BBB- rating and, secondly, a "tier two" insurer. Your thoughts, please.
R.S., Michigan
9/8/03

Mr. Klotz responds: We are a bit confused by your description of your bond purchase. We can't tell if you bought a BBB- bond, which was later insured by Radian, or whether you bought a Radian insured bond which had an underlying credit rating of BBB-. Either way, we don't assess the Radian Insurance as a second level of risk. The insurance is a credit enhancement, which raises the overall quality of your investment to AA status. Bonds rated AA are toward the upper level of investment quality ratings.

What if?

Just finished reading the Bond Forum about the SIPC insurance issue (see below, "No need to freak out"). Great topic! It calls for a follow up on a different but related issue: Being a California resident and owning significant tax-free bond positions, I have been concerned over the number of AAA-rated bonds carrying insurance. My research has confirmed that such policies indeed cover both the principal and income payments promised by the bond issuer to maturity. (By the way, is that 100% accurate?)

Not to harp on Enron or WorldCom, but it is possible that in this state's crippled financial and political situation, there may come a time when the state agencies try to walk away from their obligations (I know this is a doomsday scenario, but it is not farfetched that some in government would want to wipe the slate clean and start anew under the guise it is "good for the masses.") Sort of a government amnesty program, if you will. This sort of thing happens quite frequently in third-world countries with their currencies. Would or could the insurers handle a full-fledged meltdown of the California muni bond market? Would they want to or have to? My gut tells me that, with the plethora of AAA-rated bonds being issued (and insured) by municipalities and agencies on shaky ground, there are increased risks, even on insured munis, if a 1930s style event takes place triggered by an unforeseen circumstance.
J.T., California
9/5/03

Mr. Klotz responds: You are correct. Bond insurance contracts insure the prompt payment of principal and interest as scheduled in the bond indenture.

We can't argue that many politicians may want to wipe the slate clean, but the chances of this happening are remote. Municipal finance requires the ability to borrow for long-term projects such as sewers, schools, roads, etc. Walking away from existing debt would effectively close the capital markets to these issuers.

A 1930s deflationary environment would certainly have an adverse impact on all borrowers, including municipal bond issuers. It is difficult to determine the effectiveness of bond insurance in a hypothetical massive default scenario. Municipals did, however, have an enviable track record in the '30s. The number of municipal bond defaults was not significant and almost all of the affected bonds were eventually paid.

In regard to the financial wherewithal of municipal bond insurers: we are forced to rely on regulators, rating agencies and reserve requirements for our peace of mind. None of these factors, unfortunately, is likely to avert a possible "doomsday," but neither will the FDIC or life insurance and casualty companies in a disaster of the magnitude you describe.

Return vs. peace of mind

I have been advised to invest in BBB-rated municipal bonds (last rung of investment grade), since the probability of default is extremely low. This would provide me with a greater rate of return then AAA/AAA bonds. My plan is to invest and hold until they mature (all are long term, 20 to 30 years). Since I will be retiring soon, my goal is pure income. Also, BBB municipals are the equivalent to AA rated corporates. Is this good advice?
W.Y., New Jersey
9/05/03

Mr. Klotz responds: Our thoughts are somewhat contrary to the advice you have received. Although the default rate on BBB munis is extremely low, in today's market, we don't think you are being compensated adequately to take on the additional risk.

A stable BBB, long-term bond issued today would yield approximately 5.80%, while a AAA-insured bond would yield approximately 5.25%. The difference in income on a $50,000 investment is $275 per year. In the current economic environment, characterized by higher than normal debt levels, we would opt to trade the additional income for considerably more peace of mind.

It must also be noted that the income difference is even less significant if you step up to an A or AA-rated security.

Bond basics

I am interested in buying California municipal bonds, but unlike the stock market, it seems awfully hard to compare prices of similar bonds between different brokers. How does one know if the quoted price is unfair, fair, good or best? If I telephone several brokers asking for bids on a hypothetical CA muni bond, a day or so might pass before I receive the prices. And even if the answers came sooner, the brokers would all say that the price is only approximate from their bond desk. What is your advice on how to select a broker if getting a good price - maybe even the best price - is important (naturally, I mean if all else is similar in terms of service and ethical practice)? How much markup do you think is fair?
L.S., California
9/04/03

Mr. Klotz responds: Thank you for your inquiry. I'll try to provide some simple rules of thumb to assist you in this process.

Buying California bonds - or any other tax-free bonds - at a proper market price should not be as difficult as you make it sound. First, let's clarify some terminology: If an investor wants to buy tax-free bonds, he/she asks the broker for an offering. If an investor wants to sell bonds, he/she asks the broker for a bid. In either instance, the broker should make a "firm" bid or a "firm" offering. Neither should be approximate and neither should require a "day or so" for a response. The only time you should receive an approximate price is if you request a market evaluation of your bond holdings.

Who's your broker?
Naturally, we recommend that you buy your municipal bonds from a bond specialist firm. (That's why we founded FMSbonds 25 years ago.) You will be speaking with a broker who deals exclusively in tax-free bonds and will be better equipped to answer your bond questions.

Bond pricing
How do you know if a bond offering is reasonable? A little bit of homework and some common sense go a long way. Because municipals do not trade on an exchange, there can be slight differences in offerings. In our experience, most dealers offer bonds at fair market prices, particularly when offering higher quality securities. If you are in doubt, check out the Bond Market Association (www.investinginbond.com). There is a chart, updated weekly, on its home page that displays representative market yields on munis of various quality and maturities.

Although the chart cannot provide exact pricing for any specific issue, it is an excellent tool for determining whether the price of the bonds your are being offered is "in the ball park."

For more fundamentals on municipal bonds, please visit Bond Basics.

Tobacco bonds

Thank you for your ongoing analysis of tobacco bonds; I'm curious if your opinion has changed with regard to their credit risk. Although S&P's downgrade (on 8/28/03) won't shock anyone, its comments about declining revenue streams are somewhat poignant and will likely dominate discussions well after the Illinois litigation is resolved. Is there a substantial risk that owners of longer dated maturities will not see their principal returned, or is the more realistic risk that payments will be made, but delayed past the original "average life" calculations?
T.F., New York
8/31/03

Jay Abrams, Chief Municipal Credit Analyst, FMSbonds, Inc., responds: S&P's downgrade was expected based on its prior comments. The rationale it provided added little new insight and, in fact, did not accurately represent many of the key rating factors that affect the bonds. In its release, S&P indicated that the litigation environment has grown worse when, in actuality, the environment has improved. The plaintiffs have lost a number of class-action lawsuits filed against the tobacco companies and classes have been decertified. The U.S. Supreme Court, in the State Farm decision, sharply limited punitive damages, which will have the likely effect of reducing future jury awards to plaintiffs. Further, market shifts from the larger tobacco companies to smaller manufacturers have declined in recent months with market shares stabilizing.

Although overall shipment declines have been greater than originally anticipated, they have not declined to the point where Master Settlement Agreement (MSA) payments to the states will be so low as to threaten debt service payments. Fewer states have enacted tax increases on cigarettes this year than last year, and increased state enforcement actions against non-participating manufacturers has helped to keep expected revenues in the acceptable range. For "turbo" payments to stop or be sharply reduced (lengthening the average life), a greater decline in shipments would have to occur over a sustained period of time - a situation we have not seen and don't anticipate at this time.

No need to 'freak out'

I read an article in The New York Times about the safety of securities in the event a major bank or brokerage collapses now that excess SIPC coverage is being canceled across the United States. The sentence in the article that alarms me is as follows:

"Coverage varies from policy to policy, but typically the insurers promise to cover up to $100 million for each customer, with no limit on the total number of customers. If a huge brokerage firm with millions of clients and hundreds of billions in client assets collapsed, the insurers say, the policies could bury them in an avalanche of claims."

This sentence implies my securities (over $500,000) are not safe in any one firm. The fact that all this insurance is being canceled also implies my assets about SIPC are not safe.

If my bonds would simply transfer to another firm in the even of a huge brokerage collapsing (and I assume the same would hold true for stocks, money markets, etc.), what is the risk these insurers are not willing to take? Who can solve this mystery? Can you put an article on this issue on the internet? Is my principle (bond principle) above and beyond SIPC at risk in any way? I am not talking about market value (I know that is not insured), but the principle itself.

Please explain why I should be willing to accept a risk that all the major US insurance firms are not willing to accept (even though they are being paid to do so). If it was simply a matter of not making enough money on these policies, the insurers could raise their rates. If one aspect (say cash in money markets) was too great a risk, they could reduce the coverage of that item. What horrible risk,is lurking out there that they are simply canceling excess SIPC coverage on all the major banks and brokerage house policies?

I understand that I could take possession of my bonds or spread the assets around so no one firm's limits go over SIPC coverage. However, I would only do that if there is a risk to my holdings that are over SIPC coverage. It would be easier for me to only have to look at one statement, have one contact (even if I buy bonds from multiple places), and not have to do all the paperwork myself (i.e. partial calls etc.).

I can't be the only investor freaking out about this. Please put the answer on the Internet. I'd like to see something in writing on this, rather than just have the verbal assurances I have received from multiple sources.
B. R., Washington
8/22/03

Michael Seligsohn, Chief Financial Officer of FMSbonds, Inc., responds: This probably won't make you feel any better, but you are not the only one "freaking out" with regard to the decision by several major insurers to discontinue writing unlimited "excess SIPC" insurance coverage. The executives charged with risk management at major brokerage firms are also losing some sleep over this issue.

Background

As you are probably aware, all brokerage firms holding customer securities are required to become members of The Securities Investors Protection Corporation (SIPC). SIPC insures all accounts up to $500,000, including up to $100,000 in cash.

Since the mid '70s, after the elimination of fixed commission rates, larger brokerage firms shifted their focus to client asset gathering. As these efforts became increasingly successful there was a greater need to provide additional account protection (excess SIPC).

The original policies of this type increased coverage by $1 million or $2 million. Even as recently as 10 years ago, accounts were seldom insured for more than $25 million. However, asset accumulation, merger mania and the proliferation of "private client" business in the late 1990s resulted in the larger firms purchasing $100 million and, finally, unlimited account protection policies.

What changed?

Actually, nothing really changed except the insurers' assessment of risk. In recent years they have witnessed previously unimaginable events such as the massive fraud at Enron and WorldCom as well as the 9/11 tragedy. The insurers have now focused on the enormity of the assets under management in the large brokerages. These firms have gathered so much of the investing public's assets that each time an insurer writes a new unlimited SIPC policy, their entire balance sheet could be on the line. With the new perspective of insurers since 9/11, this is a risk, (however remote) that they are no longer willing to take.

What will happen to account coverage at these large firms remains to be seen. However, it will probably be some combination of new (possibly overseas) insurers entering the market, firms lowering their "excess SIPC" limits to amounts that will allow insurers to quantify their risk and rate increases for this type of insurance.

Bigger is not always better

How does this contrast to the account coverage at FMSbonds? Our focus has never been to accumulate the assets of our customers, although many customers do choose to safe-keep their securities here as a matter of convenience and to take advantage of the specialized services that we can offer the individual municipal bond investor (Our assets in safekeeping are just under $2 billion). We have been providing account protection of up to $25 million for some years now, and these limits are adequate for all but our largest clients, many of whom still keep their securities here for the reasons mentioned above, as well as our excellent reputation in the industry. Additionally, we have been assured by our carrier that we will be able to continue to offer this protection.

Don't freak out

All this being said, "Excess SIPC" is the third, and final, line of customer account protection. First, there are the Security and Exchange Commission's "Net Capital" and "Customer Protection" rules. These rules are designed to force brokerage firms to maintain certain capital levels and safeguard customer assets, and it prohibits them from co-mingling those customer assets with their own. These rules have "early warning" levels that notify examining authorities (FINRA, SEC, CFTC and the various exchanges) as well as the SEC if a firm is even close to becoming insolvent. The SIPC coverage mentioned above provides the second line of account protection.

It would take an extremely well thought out fraud to get past these two lines of customer account protection. In fact, in the 33 years that "excess SIPC" has been available, a total of 304 broker-dealers have failed. Of these, the largest aggregate amount that has not been covered by SIPC was approximately $39 million. That was for the entire firm, and was spread out among all their customers.

The bottom line

It is incumbent upon the major firms to insure that their customers assets are protected. We are confident that in the end, this will be accomplished. In the meantime there is no need to "freak out" unless you are an executive of a large brokerage firm whose coverage is being canceled and need to explain all of this to thousands of customers.

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