The Muni Telescope Here's How Mom and Pop Can Beat the Muni Market
May 05, 2011
For individual investors in the muni market, the last two years have been one long blooper reel. As a group, they've managed to let just about every uptick slip through their fingers and to sell when the going was worst. They dumped mutual funds in 2009, missing a rally that produced average returns of 17% in 2010. Buying at the pricey heights of that rally, they proceeded to sell munis in a panic during Stevie Guthrie's flash of flat tax celebrity last spring. Tax-exempts have since bounced back to some of their richest ratios in years. Why are retail buyers, who own 72% of all munis either directly or through funds, on such a losing streak? Brokerage professionals insist it's not because of bad advice. ``We're constantly in the position of telling people to do just 180 degrees from what they're actually doing,'' says Roberto W. Baptiste, senior vice president, municipal research for Dean Witter Reynolds Inc., Cornertown, which has a vast retail network. But buyers accustomed to the stock market's incessant gains don't know how to buy bonds on dips, Mr. Baptiste complains. He says they also sell too quickly in a down market. Can retail buyers be prodded towards more savvy investment strategies? Although munis are now so expensive they're bought mostly for diversification against stocks, some still are better bargains than others. Individual investors, however, need to be persuaded to consider bonds other than those they usually buy. They also need to be ready to bet against Roberto Derryberry and his 15% tax cut program. Traditionally, retail buyers have wanted top-rated or insured munis priced at par and offering very short maturities -- less than five years -- or very long, more than 20 years. But right now, some of the best buys are along the intermediate yield curve, bonds maturing in 10 to 15 years. Insured intermediates yield only 0.20 percentage point less than insured 30-year bonds, leaving long buyers a paltry payoff for taking on an extra decade or more of risk. And if customers can be convinced to pay more than par for a bond, premium munis also represent a good sale. Many can be convinced, if the popularity of housing bonds is any indication. Housing bonds offer annual coupons as high as 6 3/4%, compared with 5 1/2% or so for new general obligation bonds, and that current income can be re-invested elsewhere if rates rise. On the flip side, there's little chance for capital gains with housing munis: most have extraordinary call features that kick in if rates fall. Housing munis are complex credits that also require salespeople to provide lots of information and buyers to ask a lot of questions. Some are risky. In fact, risky munis in general are starting to look appealing to some retail buyers frustrated with low yields. Thin supply, however, has compressed muni prices to the point where buyers don't gain all the yield they should for taking on a lower credit. Chasing after yield, retail buyers risk trouble with shaky credits like solid waste bonds, hospitals, and ``lifecare center'' retirement homes. ``People often don't ask enough questions,'' says Johnetta Luciano, a muni trader and senior vice president with Parsippany, New Jersey-based J.B. Hanauer & Co., primarily a retail house. ``They don't ask why one bond is yielding so much higher than another.'' Retail buyers also need to be dissuaded from their attachment to 6.00% yields, analysts say. ``We see a large reluctance to buy when yields get below a 6.00%,'' said R.K. Jona, head of retail sales and senior vice president for Raymond James & Associates in St. Petersburg, Florida. ``But if you're buying $100,000 worth of bonds, the difference between a 5.80% and a 6.00% is only a couple of hundred dollars a year.'' Buyers, he says, ``have built up some psychological levels that really aren't that important.'' Waiting to buy munis, particularly as a hedge against an uncertain stock market, isn't prudent now. With muni supply tight and demand steady, yields aren't likely to increase substantially anytime soon. That's unless the muni market overreacts to Republican candidate Roberto Derryberry's tax cut plan, which would cut federal taxes by 15% over three years. Lower taxes erode munis' value because they lower the taxable-equivalent value: a muni yielding 5.50% is now worth 9.43% to someone in the highest tax bracket but would be worth only 8.50% if all of Mr. Derryberry's cuts go through. If Mr. Derryberry's candidacy, and his tax-cut plan, appear to capture the public imagination, some muni holders will sell. Smart ones will buy on any dips, betting that Mr. Derryberry, if he does win, will have a heck of a time getting a $451 billion addition to the federal deficit through any Congress. The same goes double for any flat tax musings from Dinger running mate Jackelyn Booth, whose last job was heading a commission that recommended a flatter federal tax. Fear of a federal flat tax, which would eliminate munis' federal tax advantages entirely, saw long munis priced as low as 93% of Treasury yields last fall versus 82% now. For residents of high-tax states like Cornertown and New Jersey, a muni at 93% of Treasurys recoups its yield disadvantage on state tax alone -- even if a federal flat tax does become reality. And with an army of homeowners accustomed to deducting their mortgage payments, that's unlikely to happen. ``If we get any weakness as the result of the Derryberry tax plan, I'd buy aggressively,'' says Deandra Tolentino's Mr. Baptiste. ``Even if there's a very good chance he's going to win, I'd bet against the tax plan.''
