Opportunities in the Muni Meltdown

Reading Time: 5 minutes

First, some personal news. My wife and I have been blessed with our first child, so I’ve been a lot less active on here lately. That said, I’ve been watching the turmoil pretty closely in the market. In particular, the bond market is starting off with one its worst years ever… and it is only April…. And it is happening when the S&P trades off, which is atypical. 

I’ve written before about how bonds probably have a place in your portfolio, despite what you may think of as a low yield. They offer a hedge. Last time I wrote this of course was the last Fed tightening cycle. You would’ve done quite well buying bonds at that time, actually. 

I write this today, treasuries are up, stocks down, with people forgetting about inflation for the moment and fearing whatever other flavor of the month they can dream up of (hard landing in China, War in Europe, Japan devaluation, global recession). 

Despite the barrage of headlines on inflation, I think the risk that still few are talking about is the bust on the other end as the Fed does begin to tighten as demand cools. I wrote about it in my bull-whip post,  and I think a lot of what we are seeing right now can be traced to supply chain issues.

Oil and commodities are a bit different, as they are rising due to the capital cycle playing out as well as another supply chain issue called “war.” Oil price increases, to some extent, is a bit different than just general inflation. 

That all said, as the Fed does slow things down, how many containers of goods are heading here right as demand softens considerably? Hm.

I won’t dwell on this because I doubt I will convince many people one way or another. From my vantage point, I’ll end by saying I am seeing a lot of normalization (or at least things not getting worse) right into a hiking cycle. 

Carnage in Munis

The PIMCO intermediate muni bond ETF is down ~7.5% YTD and the iShares muni ETF is down almost 8%.

That’s tough when starting yields were low. Heck, a 30-yr treasury issued in May-2020 is down 43 points from issuance. Tough when the coupon is 1.25% and the yield is still below 3%.  

However, the carnage leads nicely into what I am looking at buying.

I am in the highest tax bracket and live in Massachusetts. If I can find a 4% yielding MA Muni bond, that’s like finding a near-7% corporate bond. Out of state, a 4.0% muni is still like looking at a 6.2% corporate, as the table below shows.

It isn’t simple to make that comparison, though. High-yield (read: junk bonds) are currently yielding about 6.5%. So finding a corporate bond with equivalent yield to a Massachusetts General Obligation bond isn’t quite apples-to-apples (MA GO bonds are rated AA). 

Can we find any bonds that meet these criteria? 

Part of the “problem” of getting these yields in muni land is you have to accept long term maturity risk, i.e. duration. However on the flipside, locking in a 7% corporate tax equivalent for a long period of time also seems attractive to me.

Further, many Americans own real estate like myself, with 30 year mortgages locked in below 3%. So again, finding a 4% completely tax free bond seems like an attractive use of capital when I am technically short a 3% mortgage at the same time. Let me break down three interesting examples that I found in my search:

Dulles Toll Road (CUSIP: 592643DG2)

The second bond example is the DC Dulles toll road bond. This bond is backed by the revenues generated from the toll road to the Dulles airport of which there are few low congestion alternatives. At 81.625, this bond yields 4.1% to maturity. 

Revenues in 2021 were already coming back to 2019 levels, which supports that this road (and airport) are relatively resilient. Omicron did throw results under the bus compared to budget, but the trend back is obvious. 

For context, 2020 operating revenue declined by 38.2% vs. 2019. Bad, but not “completely shut down” bad.  

You could buy the first lien bonds, but I like the sub notes (third liens) for several reasons. First, the 1Ls are 0% coupon and I’m not going that far (yet). Plus, lien has a segregated reserve fund. The first three liens are funded at the lesser of the standard three prong test: 10% par; 125% average annual debt service (AADS) or 100% maximum annual debt service (MADS).

There are a few attractive covenants (iii and iv matter for these bonds). Rates charged for the toll road must provide net revenue in a fiscal year of at least (I) 200% maximum annual debt service (MADS) of all first senior lien bonds, (ii) 135% debt service of all first senior and second senior lien bonds, (iii) 120% debt service of all first senior, second senior and subordinate lien bonds and (iv) 100% debt service of all outstanding bonds. 

According to the financial disclosures they also have over 2,000 days of debt service costs on hand in cash and there are limited capital improvement projects on the horizon. We could have another pandemic for 6 years and they could still pay interest.

In essence, there is decent coverage here.  

However, due to the pandemic and a development project, this bond is rated A- (but wrapped by Assured Guaranty). I think travel will resume and has already resumed post pandemic and this seems like a strategic asset.  

I am BTFD. 

Mass 2% GO Bond (CUSIP: 57582RN93)

The Massachusetts 2% GO Bond due 2050 (I know, I know, that’s far out but hear me out), was recently trading at 95-100 cents on the dollar. Currently, they are trading at 65 cents on the dollar for a 4% yield to maturity.

This is backed by the full faith and credit of the state of Massachusetts, which I am willing to bet on.

One problem with munis like this is that buying them significantly below par opens up excess discount taxes. These rules are somewhat absurd, but if you buy a muni bond too far below par you may have to pay ordinary income taxes on the discount to par value. That said, in a world where these bonds have some chance of going back to par within the next 10 years. I’d gladly pay that tax.

By my estimates, I could see the potential for a 10% IRR using the assumption that they could go back to 2021 prices at some point in the next 10 years. 

Charlotte Water & Sewer (CUSIP: 161045QQ5)

The last bond is another Charlotte Water & Sewer revenue bond (CUSIP: 161045QQ5). This yield is lower, at 3.70% YTW, but this is a AAA bond (what is the US Federal Gov’t again?). That’s like buying a 5.75% AAA corp bond or a 4.90% treasury. 

Charlotte is a large, growing populace. The raw water sources are ample and the water treatment plants have an average 29 year life remaining. Net revenues are growing, debt is falling, and this also has about 500 days of cash on hand. Did I mention it was AAA? 

One thought on “Opportunities in the Muni Meltdown”

  1. Interesting post, and… congratulations on your first child 🙂

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.