AAA Municipal Bonds May Not Offer Best Return if Holding to Maturity

There has been a lot of discussion recently on the different yield between AAA municipal bonds and lower rated munis. A paper by the Fed seems to indicate that if you plan on holding on to your bonds, you may be better off buying lower rates munis.

There has been quite a bit of discussion lately in the Blogosphere over municipal bond ratings and how they impact return.  John Karney, in CFO.coms Dealbreaker writes:

"Here’s how Eisinger thinks the racket works. Municipalities seeking to raise money issue bonds which are rated by credit rating agencies. The agencies give them ratings that are too low. Lower ratings means higher interest payment costs. To avoid these costs, the municipalities turn to bond insurance to bolster their ratings. The ratings agencies are all too happy to help out the bond insurers by delivering low ratings because the insurers are some of their best customers.

The argument hinges on the idea that municipal bonds are under-rated. Eisinger’s evidence for this is that according to Moody’s research, almost every municipal bond would get a higher rating is they were rated with the same criteria used to rate corporate bonds. “About two-thirds would probably be triple-A if they were rated with the same criteria used to rate corporate bonds,” he writes. “The obvious conclusion is that Moody's, as the most influential of the credit-rating agencies, should simply start lifting its ratings on municipalities.”

Eisenger, a reporter for basically believes that Municipal bonds are very safe investments and that they are being under-rated so that the bond insurance companies can make money providing money on their premiums. 

Interested, I did a little digging and found a Federal Reserve article from 2005 entitled Liquidity, Default, Taxes, and Yields on Municipal Bonds.  What's inthe paper was very eye-opening for me.  The Fed paper states that:

"Although municipal bonds were traditionally considered to be only second to U.S. Treasuries in safety, defaults on municipal bonds  since the late 1970s, along with other problems, have raised concern about the credit risk of municipal bonds.  For example, of the municipal bonds issued between 1977 and 1998, 1,765 out of a total of 253,850 issues were defaulted, with a face value of $24.9  billion out of a total of $375.5 billion (see Litvack and Rizzo, 1999).  Thus, the probability of default may not be trivial and is of potentially greater concern for low-rated uninsured municipals.

 But the difference in return for munis versus treasuries (which the Fed used as a comparison) couldn't be explained just by this default risk.  Insead, what the Fed found was that:

 "Our empirical results show that the  liquidity risk premium accounts for a significant portion of municipal  bond yields.  Results suggest that investors require a higher yield on those municipal bonds whose  returns are more sensitive to aggregate market liquidity.  Within a rating class, the sensitivity of municipal yields to market-wide liquidity increases monotonically with maturity.  At the same time, controlling for maturity, the sensitivity of municipal yields to market-wide liquidity increases monotonically as the bond rating drops from AAA to BBB.  Liquidity premium explains about 7 to 13 percent of the observed municipal yields for AAA bonds, 7 to 16 percent for AA/A bonds and 8 to 20 percent for BBB bonds with different maturities.  Ignoring the liquidity risk effect thus results in an underestimation of municipal bond yields."

So what does this mean in plain English?  It means that munis are priced higher partially because they are harder to sell and that this premium goes up as the bond rating goes down.  Here's the opportunity.  If you plan on holding the bond to maturity and not selling, than you might want to think about a lower rated muni-bond.  Some good due dilligence will help you determine if the bond is safe (most lower-rated muni bonds are still considered safer than AAA Corporate Bonds) and you can pocket some extra premium.

Of course, as with any investment, be sure to check with a qualified investment professional.

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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