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Municipal Bond Due Diligence: Quality Remains?

By: Jeff Goble

There are several reasons why municipal bonds have worked so well as investments for banks. First, because of the bank-qualified restriction that limits the size of the issuer to smaller municipalities, they are in short supply and generally are in smaller block sizes.

Improving bank profitability helps support bond prices as banks of all sizes seek to shelter income from taxes by purchasing from the same limited supply of bank-qualified issues. This creates a floor of sorts on municipal bond prices.

Unfortunately, an unintended consequence of the small-issue rule is that it concentrates credit risk in smaller municipalities rather than allowing more diverse investment in cities of all sizes. An offset on the positive side is that these issues can only be used for public purposes.

Second, since 1979, bond prices have generally been rising (as rates have fallen) supercharging the total return of longer-term municipal bonds. (Total return considers both the income yield in conjunction with the gain or loss in market value.) The fact that these bond yields have been very high and locked in — with the exception of calls — has boosted portfolio yields over other banks that do not own municipal bonds. Over the past three years, this income lift has been especially apparent as interest rates have fallen so dramatically.

Third, municipal bonds are really just loans to communities and school districts in security clothing. The high-quality issues have greatly enhanced bank profitability as an asset class to help offset declining loan demand during the deepest recession of our lifetime.

Investing in municipal bonds requires regular due diligence and attention, especially when the economy is struggling. The chart lists some basic benchmarks I collected for evaluating the issues you currently own and also new purchases. I think a thorough credit review should be performed at least annually, if not more frequently, by your ALCO or loan committee and then reviewed by your board. We have automated this process so feel free to email me if you need help.

It is important to note that each municipal credit guideline should be reviewed in its entirety rather than isolating a particular benchmark. In addition, at three-decade lows in bond yields, this is not a good time in my opinion to overweight long-term municipal bond purchases in your bank’s portfolio as you would be betting against history and your own portfolio’s average yield. It is tempting now to reach for additional yield … and that is usually a warning signal too.

An old bond market adage states that “quality remains long after the yield is forgotten.” This is really true today. Keep your municipal bond underwriting standards high and independent and use dollar cost averaging and interest rate history to know when to lock in longer-term issues. Weed out weaker issues any time you can to constantly upgrade the portfolio.

You will sleep better … and enjoy the extra earnings.

Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble(at)umb.com.

Copyright © September 2011 BankNews Media


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