Muni Bonds: The Kentucky Case

Waste Haulers and the Dormant Commerce Clause

An important decision was made today in a court case involving municipal government. The case dealt with waste haulers (such as Waste Management, Inc.) suing local governments over directing waste to preferred dumping facilities. The purpose of these facilities is to dispose of the waste in an "environmentally friendly" manner. The Supreme Court ruled against waste haulers who didn't want to be steered to higher cost dumps by local governments. These governments charge the waste haulers "tipping" fees, but don't allow them to dump at less expensive facilities in other areas. The fees collected are then used as security to pay bondholders. The waste haulers argued that this process was "unfair" and violated the Dormant Commerce Clause which prohibits States from discriminating against out-of-state commerce. The Supreme Court ruled that States, indeed, have the right to force haulers to pay higher fees without allowing them to dump in other areas.

Many have argued that the reason the Supreme Court has not heard the Kentucky case is they wanted to rule on this similar case first. The Kentucky case centers on the State of Kentucky giving preference to in-state municipal securities while taxing out-of-state muni bonds. Davis, the plaintiff, and the Kentucky Appellate Court have argued that this discriminates against out-of-state commerce and is in violation of the Dormant Commerce Clause. Most states give preference to in-state muni bonds and tax the interest on out-of-state munis. The tax-exempt mutual fund industry has created a myriad of state preference funds. A negative ruling on the Kentucky case would rewrite the way states are able to tax muni bonds.

We feel these two cases are very similar. They both center around the "public interest" of a local community. In the trash hauler case, local governments force haulers to pay fees that may be higher than other nearby municipalities charge, but the public interest is served by a cleaner regulated environment. The public interest of the citizens of Kentucky is served by lower interest costs for local governments in the State of Kentucky. We agree with the Supreme Court in this case, and expect the court to use the same logic in the Kentucky case. Thus, Waste Haulers and the Dormant Commerce Clause An important decision was made today in a court case involving municipal government. The case dealt with waste haulers (such as Waste Management, Inc.) suing local governments over directing waste to preferred dumping facilities. The purpose of these facilities is to dispose of the waste in an "environmentally friendly" manner. The Supreme Court ruled against waste haulers who didn't want to be steered to higher cost dumps by local governments. These governments charge the waste haulers "tipping" fees, but don't allow them to dump at less expensive facilities in other areas. The fees collected are then used as security to pay bondholders. The waste haulers argued that this process was "unfair" and violated the Dormant Commerce Clause which prohibits States from discriminating against out-of-state commerce. The Supreme Court ruled that States, indeed, have the right to force haulers to pay higher fees without allowing them to dump in other areas. Many have argued that the reason the Supreme Court has not heard the Kentucky case is they wanted to rule on this similar case first. The Kentucky case centers on the State of Kentucky giving preference to in-state municipal securities while taxing out-of-state muni bonds. Davis, the plaintiff, and the Kentucky Appellate Court have argued that this discriminates against out-of-state commerce and is in violation of the Dormant Commerce Clause. Most states give preference to in-state muni bonds and tax the interest on out-of-state munis. The tax-exempt mutual fund industry has created a myriad of state preference funds. A negative ruling on the Kentucky case would rewrite the way states are able to tax muni bonds. We feel these two cases are very similar. They both center around the "public interest" of a local community. In the trash hauler case, local governments force haulers to pay fees that may be higher than other nearby municipalities charge, but the public interest is served by a cleaner regulated environment. The public interest of the citizens of Kentucky is served by lower interest costs for local governments in the State of Kentucky. We agree with the Supreme Court in this case, and expect the court to use the same logic in the Kentucky case. Thus, it seems likely the current system of taxing out-of-state munis and giving preference to in-state bonds will survive this challenge in Kentucky.

How do you explain to your clients about using a SAM?

We frequently hear this question from advisors: How do I explain to my clients that they should use a bond manager when we've been managing the bonds?

A portfolio of individual securities can be a tax-efficient and customized alternative to a mutual fund. In the past, advisors were able to add value because the cost of using a separate account manager was too high. With a decline in the cost of using a separate account manager, they have become an option for advisors to use for their clients instead of doing it themselves. The firm Evensky & Katz came to this conclusion in 2003 (see Harold Evensky's May 6th, 2003 article entitled, Why Hire a Manager to Pick Your Bonds? This article can be found here. Currently, this article can only be downloaded with Internet Explorer; We are sorry for the inconvenience). Below, we discuss the fees, specialization, value added, and validity of separately managed accounts.

Fees

Just as mutual funds charge fees, so do separate account managers. The separate account manager directly states the fees charged, while mutual funds disclose their fees in the prospectus. Mutual funds deduct their fees before they report performance and the client does not see the exact amount. If the investor is using a separately managed account, the investor pays fees to the manager and they are more transparent. Separately managed account fees were relatively high in the past (in the neighborhood of 1.5-2.0+%), but now they are very competitive (.25-.50+%) in comparison with mutual funds.

Specialization

Bond portfolio managers have lower transaction costs than the typical advisor. They also have access to other beneficial tools such as Bloomberg not usually utilized by an advisor. There is a great deal of specialized knowledge and detailed work that goes into managing bond portfolios. A professional money manager is able to do things that even a good advisor doesn't do.

Value Added

The cost/benefit analysis for using a separate account manager is much more favorable today than it was in the past. Customization and tax-efficiency are the main reasons to use Separately Managed Accounts. These benefits are difficult to achieve using a mutual fund. Value-adds from a SAM can compensate for the cost of professional management. In the past, separately managed accounts were marketed as customized when they were really 'expensive closet mutual funds' according to Evensky. The competition has increased over time with SMA's and money managers are discovering more ways to add value to a client's portfolio. Harold Evensky places the value of active bond management in a SMA at .10-.30% net of fees. Tax management may provide additional value to the client's portfolio as seen in the chart below.



Validity

Harold Evensky, a nationally renowned financial planner with Evensky & Katz Wealth Management in Coral Gables, FL, had this to say about altering his bond strategy: "(C)hanges in the economy led us to believe in spite of our expertise, our strategy of individual bond selection was no longer in our clients' best interests." The cost effective strategy of a bond separate account manager became available and Harold made the switch.

Conclusion

While the advisor may have done a good job in the past managing the client's bond portfolio, declining fees of separate account managers have created the opportunity to increase after-tax performance for the client. This allows the advisor to focus on managing the relationship with the client and free up time to work on other tasks.

Bonds: Harvesting Losses

There are times when it can be beneficial to realize a loss for tax purposes. Losses can be used to help offset up to $3,000 of current income a year, and capital gains from other investments. They can also be "banked" or carried forward to another year if they can't be used in an existing tax year.

The value of these losses depends upon the taxpayer's marginal tax rate and the capital gains tax rate. The first $3,000 of losses may be used to offset ordinary income. Let's say the investor is in the 35% tax bracket. The value to him/her of this loss is: $3,000*.35%=$1,050. If the size of the loss is greater than $3,000, then the remaining loss can be used to offset capital gains. For example: if the loss is $8,000, there is $5,000 of losses remaining after using the first $3,000 against ordinary income . The value of using these losses to offset capital gains is $5,000*.15= $750. We use .15% as the capital gains tax rate. This rate is scheduled to expire in 2010 and return to the .25% previous rate. The total losses harvested in this example is $1,800 ($1,050 + $750). The higher the tax rate, the more value there is in the loss.

When realizing losses for tax purposes, it is important to remember the Wash Sale Rule. This rule states that when you take a loss on a security, you may not re-purchase the same security for 30 days in order to use the loss on your return. This rule is meant to discourage investors from selling a security and immediately buying it back. If you own stock in Microsoft and realize a loss, you can't buy back MSFT for 30 days and use the loss. What works best in tax loss selling is finding a security that is a good substitute for the security you are selling. Muni bonds are the ideal securities for tax swapping. For example, if you own City of Chandler, AZ 5% coupons due 1/1/2013, you could swap these for City of Scottsdale, AZ 5% coupons due 1/1/2013 in a legalized way around the wash sale rule.

The challenge in doing these types of trades is having low transaction costs. The typical retail client is locked into a buy and hold strategy because their transaction costs are too high. For example, it would not make sense to do the swap above if your cost of doing the trade is greater than the tax savings you generate. The typical bid/ask spread for a retail client is over 2%. If the investor has a $5,000 loss, it is worth $750 to him. If it costs him $2,000 to do the trade, then his position will be impaired $1,250 by doing the trade ($750 - $2,000). Thus, he is locked into a buy and hold strategy. If, however, your transaction costs are $0, then you can save $750 in taxes by doing the trade.

There is significant benefit for investors in knowing what their transaction costs are, and in finding ways to reduce them. The lower the transaction costs, the more beneficial tax loss harvesting becomes. This will result in higher portfolio returns both before and after tax.

Muni Bonds: The Retail Model

The Problem: Retail Pricing Model

The retail broker/dealer for munis is primarily concerned with how to pay the salesperson to sell or market muni product and how the retail trader can maximize his/her trading profits. This is an incentive-based system for retail firms. Most retail brokers are paid on commission, only the commissions are buried in the offering price of the securities. A retail trader will determine what type of securities his/her sales force can sell. He/she will make an assessment that includes maturity, quality, coupon, and absolute yield levels. A retail trader also knows what type of incentive or mark-up is needed to offer to get his/her sales force to sell the firm's offerings. He/she then looks for bonds with desired characteristics and positions them in inventory for the sales force to sell. His/her ability to find the right merchandise with the right mark-up will determine how successful a retail trader is. Studies have shown these mark-ups can be significant and will be influenced by such factors as maturity, quality, and block size.




Transaction Costs For Retail

In 2004, there were two independent studies published which addressed the typical bid/ask spreads for retail muni investors. These studies are shown in the table below. The typical spread was between 2-2.50%. Most retail investors have an account with only one firm. This gives the broker dealer a captive situation, because the client is not able to get competitive offerings or bids from other dealers. This can lead to a conflict of interest on the part of the dealer and poor trade execution for the client.

Problems For Individual Investors

There are additional problems for the retail buyer of munis. These difficulties pertain to valuation of securities.

The typical retail buyer has difficulty within this model in the following areas:

1. Callable Securities- It is best to value callable securities with appropriate bond software, which can be expensive and require specialized expertise. Very few retail investors know how to use OAS (Option Adjusted Spread) to value callable bonds. Instead, they may tend to underestimate the value of calls and buy callable bonds that look attractive on a yield to maturity basis, but are very unlikely to be outstanding to maturity. If they get called, they may turn out to be unattractive instead. It is not difficult to make this valuation analysis, but it requires tools and knowledge that is out of reach of most retail accounts.

2. Credit Spreads- There are over 50,000 different issuers of municipal securities. In order to have a clear understanding of how they should trade relative to one another, the investor requires specialized knowledge and a system for valuing these securities. A retail investor may easily underestimate how wide a credit spread should be for a lower quality credit in comparison to higher quality securities. This would enable a dealer to make a larger mark-up at the expense of the unknowing retail investor. Most retail investors are “flying blind” and have no solid basis for price relationships based on credit spreads.

3. Coupon Spreads- Retail investors tend to have a preference toward purchasing par bonds (bonds priced near 100.) This makes these bonds overpriced in the market relative to other coupons available. Our studies have shown that premium bonds are less risky (they have lower duration), return principal faster (which allows us to take advantage of higher reinvestment rates in a rising rate environment), and avoid the market discount rule. We are generally able to buy these coupons at wider spreads than par bonds. This is especially true when buying in block sizes of 100,000 or less.

4. AMT- About 5% of the muni market consists of bonds that are subject to the Alternative Minimum Tax calculation. These bonds are issued with a public purpose, but there is a benefit to a private party. Stadium bonds, airports, and single family housing bonds can all be examples of AMT bonds. The trend is for more and more individuals to be subject to AMT status. We believe the spread vs. non-amt bonds could widen in the future as a result of this trend. Retail accounts may have difficulty knowing what an appropriate spread for AMT bonds should be. They may look at their own situation and if they are not in AMT status, they may undervalue the spread for AMT bonds and pay too much.

5. Maturity Spreads- Muni bonds are issued serially out to about 30 years. The yield curve is generally upward-sloping. This gives an investor an incentive to extend to pick up extra yield. It may be difficult for a retail investor to know how to value the amount of risk he/she is taking by extending for any given amount of yield. This could lead the retail account to extend too much for too little benefit.


The Solution

A professional bond manager has the necessary institutional bond tools to value the above-mentioned securities properly. These tools include Bloomberg software and The Bond Buyer, a specialized daily bond news publication. Institutional money managers have also built up an institutional network of dealer coverage that allows them to narrow the bid/ask spreads of individual securities significantly. This combination of low transaction costs, (like a mutual fund) and establishing a tax-basis on each individual security (like a retail investor) is a powerful solution to the Muni problem. The portfolio can then be tax-managed cost-effectively by doing tax-swaps when it is advantageous, and by building state preference portfolios.

Muni Bonds: Moody's Maps Muni Ratings To Corporate Bond Ratings

Moody’s Default Report

Last month, Moody’s issued a report entitled: “The U.S. Municipal Bond Rating Scale: Mapping to the Global Rating Scale and Assigning Global Scale Ratings to Municipal Obligations.” The purpose of the report is to map muni ratings to the corporate rating system.

We have felt that one of the in-efficiencies in the taxable bond market is taxable muni bonds trade too cheaply for their quality. Recent experience shows that a Aaa-rated taxable muni trades at about the same spread to U.S. Treasuries as an A-rated corporate bond. This makes no sense, because the munis are less likely to default and are not subject to the same event risk as a corporate bond. This report confirms our position on taxable munis. Moody’s shows default rates for the last 36 years on all bonds they rate. During this time period, there were a total of 41 defaults by municipal issuers considered to be investment grade (Baa or higher). Of these, only 1 default was backed by either a General Obligation pledge or Water & Sewer Revenues. These types of bonds have a very low risk of default. The chart below shows that an investment grade corporate bond has a 2.1% chance of defaulting during the next 10 years, while an investment grade muni has only a .1% chance of default, according to the study.

Moody’s separates munis into different categories and then maps them to corporate ratings.

Here are some of their conclusions:
1. An A-1 rated state GO is equivalent to a Aaa-rated Corporate Bond.
2. A Baa-2 rated local GO is equivalent to a Aa-3 rated Corporate Bond.
3. A Aaa-rated Corporate Bond is 5 times more likely to default during the next 10 years as an investment grade muni bond.
4. The risk of default by a State GO, local GO, or Water & Sewer revenue bond is much lower than other categories of muni bonds.
5. Local lease obligations and special tax, electric & gas for transmission, mass transit, public higher education, general airport revenues, and existing toll roads have all shown superior risk profiles.

Conclusions

There is less credit risk in certain types of muni bonds than the ratings imply because of their superior risk profiles. Moody's recognizes in this report that State and local GO's may be under-rated by their existing rating system compared to their Global Ratings for Corporate Bonds. Some Muni investors may wish to buy lower rated investment grade GO's and Water & Sewer bonds if they are over-compensated for the additional credit risk taken. Moody's estimates that about 50% of the Muni bonds they currently rate as Baa will be upgraded to A-rated in the near future. This may create opportunities for "spread tightening" trades. Unfortunately, credit spreads in the Muni market are currently relatively tight by historical standards. So, it may be difficult to take advantage of these potential upgrades by Moody's. The better opportunity for spread tightening may be in the Taxable Muni market where quality spreads still have plenty of room to compress.