By Chris Thompson
In 1959, RCA Victor sold a compilation of Elvis Presley’s greatest hits, officially titled “Elvis’ Gold Records.” Later presses added the boldfaced phrase “50,000,000 Elvis Fans Can’t Be Wrong” to the cover and this became the de-facto album title. The phrase referred to the voluminous record sales the King of Rock ‘n’ Roll amassed to date in his legendary career. In modern parlance and on any topic whatsoever, it’s not unusual to hear a pundit defend a challenge with the universal justification “50,000,000 Elvis fans can’t be wrong!”
An observer of the municipal bond market could make the same claim. Municipal bonds have been one of the most successful financing tools and investment strongholds of the past century. Despite post-election hesitations about the relative value of tax-free bonds (if marginal tax brackets are notched lower), occasional muni investors may be surprised to know the municipal bond market shares Elvis Presley’s magnetism … it continues to defy and surpass expectations. But this is nothing new. Consider the following:
- During the last round of Federal Reserve rate hikes, from 2004-2006, long-term muni bond prices soared while Treasury prices declined. Municipals greatly outperformed the benchmark curve and were recognized as the top-performing asset class.
- During the Great Depression, there were thousands of muni bond defaults, yet only a few dozen issuers (a rounding error) failed to fully repay their debts.
- At the height of the Great Recession, financial analysts predicted imminent doom for muni bond investors. Notably, one-time superstar analyst Meredith Whitney (who correctly predicted Citibank’s 2007 dividend cut and the coming financial crisis) told TV’s 60 Minutes, “There’s not a doubt in my mind that you will see a spate of municipal-bond defaults,” which she estimated would amount to “hundreds of billions of dollars.” Oops! The number of muni defaults actually declined from 2010 to 2015, and that guess about hundreds of billions turned out to be hundreds of billions on the high side.
- Municipal bonds have survived other “bumps in the road,” including world wars, hyper-inflation, high-profile bankruptcies (though rare), foolish arbitrage schemes (Orange County, Calif., and Jefferson County, Ala.), insurance failures, innumerable floods, fires and snowstorms of biblical proportion, sequestration, debt limits and the fiscal cliff budget debate in 2013, which considered capping tax-exempt income at the 28 percent marginal tax rate. Time and again, muni bonds rise and shine through a morass of threats and predictions of doom.
And 2016 was no exception. Muni fund inflows eclipsed outflows, even though the last two months of the year were decidedly bearish in this regard. But for sage buyers that arrived to feast upon the indiscriminate selling, the post-election conniption proved to be an early Christmas present. A mid-December Wisconsin Bank Qualified General Obligation issue illustrates the advantage:
Aa2 Oconomowoc WI Schools BQ GO
3.50% 4-1-2036/2025 $103.629 3.00%ytc 3.245%ytm
Assuming a 0.75 percent cost of funds and the current top 39.6 percent federal bracket, this issue produces taxable equivalent yields of 4.86 percent to call and 5.27 percent to maturity, which were 220 basis points and 250 basis points of spread, respectively, vs. the Treasury curve.
Now assume funding costs rise 0.50 percent (to 1.25 percent) and President Trump’s tax plan prevails, dropping the top bracket to 33 percent. The resulting estimated taxable equivalent yields become 4.35 percent to the call and 4.72 percent to maturity. Accordingly, spreads drop to 168 basis points and 196 basis points respectively.
In both scenarios, investors have a solid credit earning attractive triple digit spread compared to US Treasuries and a durable income stream with significant call protection. Additionally, by mid-January, new issues with similar terms and credit profile priced 30-40 basis points lower. Once again, munis surprise to the upside!
“Suspicious Minds” didn’t believe the selloff when the market was “All Shook Up” and checking-in to the “Heartbreak Hotel.” You shouldn’t either. Elvis may have left the building, but munis are here for the long run.
Chris Thompson is executive vice president in the Capital Markets Group at Country Club Bank in Kansas City.