Investing in municipal bonds can be a complicated process. Unlike the more plain-vanilla structure of US Treasury bonds, municipal bonds can have a wide range of features and structures that make the “muni” market far more esoteric. The municipal bond market is also less deep and liquid than the US Treasury market, making municipal bond prices more susceptible to small changes in supply and demand. As a result of this relative lack of depth and liquidity, relationships with multiple brokers can be a very important factor in getting access to bond supply as well as demand. Finally, the municipal market is greatly driven by the maturity and issuance flows of the calendar, providing insight for those managers that have many years of experience operating in these markets. Each of these factors provide managers of municipal bond funds and portfolios ample opportunities to add value for clients.
The process for investing in municipal bonds for any individual client involves both objectivity and subjectivity. Many factors go into the screening exercise. From a macro perspective, we first need to determine if the yields available in the municipal bond market are competitive to other fixed-income investment vehicles based on the prospective investor’s income-tax rates. Applying the appropriate tax rates to all the investment candidate’s investment opportunities results in a more apples-to-apples comparison. Another big-picture decision is determining the investor’s appetite for interest-rate risk based on our outlook for future changes in interest rates. Prices for longer-duration bonds are far more sensitive to interest-rate changes than shorter-duration bonds, and so the decision to extend or reduce duration can have dramatic implications on investment performance.
Tailoring the correct bond search parameters for each client involves a complete knowledge of the client’s profile and goals. Key factors affecting bond selection are the client’s age and succession plan for the portfolio, his/her dependence on the interest income the portfolio generates, and his/her risk tolerance, to include credit risk, interest-rate risk and reinvestment risk. These are the hallmarks of successfully matching bond selection and client goals.
Once we have a handle on what category of fixed-income security is most appropriate, whether taxable or tax-free, we need to find worthy bond issuers. Again, that is driven by the supply available from both the primary (new issues) and secondary markets. Sometimes the prudent choice is to wait for better supply and therefore better choices to invest. We would not call this market timing so much as market temperature. Ideally, we want to be buying in a buyers’ market with ample supply and therefore a wider range of choices.
Credit selection is the most important factor in any type of bond investing. Capital preservation is paramount. A good place to start in the process of credit appraisal is the issuer’s credit ratings, which are provided by the rating agencies S&P, Moody’s and Fitch, among others. We read the credit reports and verify how contemporary the credit reports are. We also analyze the trend in ratings changes for any issuer, with a preference for municipalities that have experienced recent ratings upgrades rather than downgrades. But the process doesn’t end there. We at Farr, Miller & Washington take the additional crucial steps of analyzing the most recent financial statements of an issuer. We are looking for issuers with positive operating performance and assets well exceeding liabilities for several years out into the future. More subjective scrutiny involves looking at population trends, including income and wealth levels, of the issuer’s taxation base or service area. Ideally, we want to invest in municipalities with stable or growing tax bases or revenue streams.
At Farr, Miller & Washington we take the time to invest in fixed-income securities thoughtfully and carefully. Many additional small, detailed factors color our decision to invest or pass on a prospective bond, and these more subjective techniques only come from decades of discernment and scrutiny.