January 2008 Taxable Municipal Bonds: An Investment Opportunity by Rip Reeves One of the chief responsibilities of portfolio managers is to Second, taxable municipals have low credit risk, and issuers almost be on the lookout for attractive investment opportunities that never default – unlike some taxable investment-grade corporate make sense for our clients’ portfolios – and to ask for changes issuers of recent years. Taxable municipals also have no LBO risk, in portfolio guidelines where necessary in order to exploit these given the quasi-public nature of their issuers. opportunities on behalf of our clients. At the moment, we see an allocation to taxable municipal bonds as an attractive way to Ten-Year Cumulative Default Rates increase both portfolio income and potential total return without a 1970-2000 commensurate increase in overall risk, however risk is measured. Munis Corporate AAA 0.00% 0.68% Taxable municipals are generally private activity bonds where a AA 0.03% 0.80% signiﬁcant portion of the issue proceeds beneﬁt a private rather A 0.01% 1.47% than a public source, making them ineligible for federal tax BBB 0.06% 4.86% exemption. Typical uses of proceeds are replenishing an under- Investment Grade 0.03% 2.32% Speculative Grade 1.93% 32.04% funded pension plan, ﬁnancing investor-led housing or athletic stadiums, and refunding a previously refunded issue. The taxable Source: Moody's municipal market has grown signiﬁcantly in recent years and now represents approximately 6% of the total municipal market of $2.5 trillion. Issuance has averaged $30 billion annually over the last Third, taxable municipals have historically provided lower volatility ﬁve years, while 2007 issuance through September has reached $19 of returns than other taxable sectors. The return streams of taxable billion. Taxable municipals have been included in the Lehman municipals have been much more stable than those of corporate Brothers Aggregate Bond Index since 2003. bonds. Taxable municipal bonds possess several qualities that make them Volatility (Standard Deviation of Total Return) particularly attractive for inclusion in investment-grade insurance 3 yrs ending 9/30/2007 portfolios. First, as shown in the table below, taxable municipals Taxable Muni 4.41% oﬀer an attractive yield spread over Treasuries. Additionally, their Treasury 4.28% Agency 4.57% yield advantage compares favorably to lower-rated taxable corporate Corporate 5.32% bonds. Source: Standish Taxable Bond Spread vs. Treasury (5 YR Maturity) 12/31/2007 Taxable Muni AAA Insured +120 BPs Taxable Corporate Industrial AAA +63 BPs Fourth, the majority of taxable municipal bonds have no call Taxable Corporate Industrial AA +88 BPs feature and thus no prepayment risk. While some housing bond Taxable Corporate Industrial A +116 BPs issues may have embedded prepayment options, PAC structures Taxable Corporate Industrial BBB +173 BPs generally serve to provide prepayment protection for investors. Source: JP Morgan, Standish January 2008 Taxable Municipal Bonds: An Investment Opportunity by Rip Reeves Fifth, taxable municipals are priced and commonly traded oﬀ Besides oﬀering strong relative value in today’s markets, taxable the US Treasury yield curve, so they are closely correlated to US municipal bonds possess certain inherent and longer-term Treasuries. Their average yield beta is 0.95. As a result, adding advantages that make them attractive candidates for inclusion in the taxable municipals does not complicate the portfolio duration opportunity set of investment-grade insurance portfolios. Taxable decision, as can tax-exempt municipals, which have a much lower municipals oﬀer high quality, attractive yields, and low risk, in yield beta to Treasuries. terms of both credit and volatility, particularly when compared to taxable corporate bonds. We expect issuance to continue to trend Every investment has its risks. The chief risk in owning taxable higher with increasing demand, as both institutional investors municipal bonds is their relative illiquidity. Taxable municipal (insurance companies, pension funds, and foreign buyers) as well as issues are generally smaller in size, averaging $33 million for 2006; individual investors begin to take advantage of this attractive and and the heaviest trading activity tends to be concentrated in the growing investment opportunity. largest issues. Given the relatively higher cost of transacting in this market, these bonds should probably be thought of as longer-term “core” holdings in the portfolio. We currently recommend a 5% allocation in taxable bond insurance portfolios. One Boston Place, Suite 2900 · Boston, Massachusetts 02108-4408 This information is not provided as a sales or advertising communication. It does not constitute investment advice. It is not an oﬀer to sell or a solicitation of an oﬀer to buy any security. Past performance is not an indication of future performance. This information is not intended to provide speciﬁc advice, recommendations or projected returns of any particular Standish product. Some information contained herein has been obtained from third party sources and has not been veriﬁed by Standish Mellon Asset Management Company LLC. Standish makes no representation s as to the accuracy or the completeness of any information herein.