The Arsenal Files 4/The Arsenal Files 4 (Arsenal Computer).ISO/business/muni213.txt

Text File | 1995-02-18 | 12KB | 248 lines

SMITH BARNEY
MNNICIPAL INVESTORS MONTHLY
FEBUARY 1995

For quite some time, we have been writing about an
impending shortage of municipal bonds. To be honest. that
discussion probably started a bit early, as declining/low
borrowing costs kept new issue volume in the municipal bond
market artificially high through March, 1994. Subsequently,
increasing interest rates caused refunding volume to decline
sharply pulling total volume well below prior year levels.
Refunded volume became the primary swing factor in new issue
supply, since it comprised well over half of new issue volume in
1993, the all-time record year. By the second quarter of 1994,
volume was beginning to plummet. Total issuance dropped 44% in
1994, to $164.4 billion from $292.0 billion a year earlier. For
the period April- December, however, the drop was even more
dramatic; down nearly 50% from year earlier levels.


For quite a while , the drop in financing was hardly
noticeable to most investors.  The chief reason was that bond
funds, which had dominated the demand side of the municipal bond
market for several years, began to Experience liquidation as
interest rates rose. Nevertheless, the "day of reckoning" in the
municipal bond market - the time when investors would truly
begin to notice a shortage of many types of municipal bonds was
rapidly approaching. Well, it's here. Volume in December 1994
was $9.94 billion, 62% below year-earlier levels. Volume in
January 1995 was $7.24 billion, the lowest monthly total in five
years. Meanwhile, bond calls are at all-time highs, and will
stay at or near these levels through 1996. These bond calls
generate demand, which will be difficult to meet in the current
supply-shore environment. In the following. we discuss why
supply has declined so drastically, implications for the
municipal market. and  consequences for municipal  portfolio
strategy. Next, we discusscuss -- yet again- "market
discountcount" bonds, one sector where supply remains decent, if
not overwhelming. Finally, we begin a series of articles on
municipal credit trends. Credit analysis has been an under used
tool in municipal portfolio strategy for many years, largely
because default and credit crises have been few and far between.
Recent problems such as those in Orange County, California,
Essex County, New Jersey and Washington, D.C.. suggest that the
importance of credit analysis in the municipal bond market may
be on an upswing.



Why Supply Is Down - and Why You Should Care.

The chief reasons for the drop in new issue volume
are related to the interest rate cycle. Refunding volume
skyrocketed in 1992 and 1993 as interest rates dropped toward
their cyclical lows. Indeed, of the $292 billion sold in 1993,
roughly $180 billion or 61% was in the refunding category.

Refunding volume is down sharply as a result of the
rebound in interest rates, but also because the vase majority of
refundings that could he done was already accomplished by early
1994. Refundings comprised only one fourth of 1994 issuance, and
much of that sold early in the year, before interest rates
spiked. Furthermore, we suspect that new money financing will
stay surprisingly low for a while. The forces that swept a
Republican majority into Congress, based in part on a distrust
of "big government" may also slow capital spending and thus debt
issuance at the state and local level. Why should all this
matter! Very simply, because the supply of attractive paper that
meets the needs of individual investors is plummeting.
Furthermore, investors who maintain very narrow parameters as to
the type of bonds they will buy will find it particularly
difficult to build and maintain municipal bond portfolios.
Finally, certain sectors can become seriously overvalued during
periods such as this one, and investors should seek alternatives.

Two sectors that are experiencing particularly tight
supply, which is unlikely to reverse any time soon are:  Current
coupon intermediates issued in high-tax "specialty" states; and
Pre-refunded bonds, particularly in high-tax states. The limited
amount of current coupon intermediate paper issued tends to
disappear into investor portfolios as soon as if is issued.
Pre-refunded bonds on the other hand, are simply being redeemed
as their first call date arrives. We estimate that, by late
1996, roughly 75% of the pre-e's outstanding at their peak in
the early 1990's will have been redeemed.

In past MIM's, we have noted some of the alternatives
that investors should consider when supply in their favored
sectors are scarce or overvalued. Some of these include:

Shorter maturity insured bonds instead of pre-refunded;
Discount or premium bonds in place of current coupon  bonds.
(See the discussion of "market discount" bonds,  below.);

High quality revenue bonds in place of similar  rated GOs,
particularly in longer maturities;
 1- 3 year Treasures and agencies, in cases where such instruments
yield as much or more than municipal alternatives, on an after-tax
basis;

Out-of-state bonds, including so-called "general market" paper,
in states with low or moderate tax rates and a dearth of
in-state issues. We find that investors in certain states are
overly resistant to out-of-state paper, even when that paper
yields as much as in-state bonds, after payment of the sate tax.
States that come to mind include Florida, Connecticut, Colorado
and Pennsylvania. "General Market" bonds are usually defined to
include l) bonds Issued in states that do not tax interest
income directly or indirectly, such as Washington and Texas; 2)
bonds  issued in states that do not exempt in-state paper, such
as Illinois; and

3) very large bond issuers whose financings must be
priced to attract out-of state investors. It should also be noted
that the purchase of out-of-seate bonds provides an additional
advantage- increased diversification.

The premium on flexibility and agility. We have noted
in previous MIM's that during periods of tight supply, investors
will have to be able to build and maintain a municipal bond
and/or overall fixed income portfolio that meets their needs as
to after-tax yield, safety and liquidicy. We have clearly
entered such a period, which is unlikly to end anytime soon.
What we mean by "flexible and nimble" includes:

Consideriy alternatives that are similar to those
previously purchased, but may differ slightly with respect to
one or more investment parameters;

Being ready to act quickly when bonds that do meet
your needs become available, or risk having those bonds sold
eleswhere;

Making sure that investment professionals who
provide you with investment suggestions (such as your Smith
Bamey FC) know as soon as possible when you have cash to spend,
bond call/maturity proceeds to reinvest; or a need to
restructure your existing holdings. When supply is tight, the
best results can often be achieved if an investment professional
has maximum time to "work" an idea -- e.g., by searching fer
bonds that meet your needs, that may not currencly be in
inventory.

Investors Should Consider Market
Discount Bonds.

As noted above, attractive municipal bonds are
scarce. That scarcity is even worse for investors who are
unwilling or unable to buy certain types of bonds. One sector
which many investors have avoided is so-called "market discounr"
bonds.

The 1993 budget/tax package included a provision
that changes the tax treatment of "marker discount" on
municipal bonds. Market discount on a municipal bond is now
treated as ordinary income incurred when the bonds are sold or
mature, rather than capital gains. For example, suppose that a
bond is issued at par, but declines to 90 in the secondary
market, as a result of increasing interest rate levels. If a new
investor purchases the bond at 90, and holds it to maturity, the
10 points of gain is taxed as ordinary income at the holder's
marginal tax rate. In reality, the change in tax effect
is quite modest, although the effect is greater on
shorter maturities than it is on longer maturities.

For example, on a 20-year 5.25% bond purchased to
yield 6.25%, pre-tax, the after tax yield is 6.16% under the old
tax law, where the discount was taxed as capital gains, and
6.13%, under current law in the 36% Federal Brackct. In other
words, the tax effect of owning a market discount bond was very
modest under previous law, and is only slightly more problematic
under the current law.

In tax brackecs below 39.%, the effecs of the change
in tax treatment is proportionately lower - under one basis
point on 20- to 30-year bonds in the 30 % bracket. What about a
30-year bond sold in one year? Remember that market discount
accrues over the life of the bond. The tax effect resulting from
a much shorter holding period than the time to marurity is
negligible. It is also important to note that the tax law change
included a "de minimus" or "safe harbor" provision. If the
amount of market discount is less than one quarter of one
percent times the number of years to maturity, old tax law
treatment applies. For example, on a 20-year bond issued at par,
the price would have to fall below 95 before the new treatment
applies (1/4% x 20 years = 5 points of discount); otherwise the
gain is taxed as a capital gain rather than ordinary income.
Market discount bonds possess three advantages, relative to
current coupon bonds, in the current market environment. First,
they are mbre readily available in many states, sectors and
maturities. Second, they have better upside potential than
current coupon bonds, should municipal interest rates continue
to decline. Finally, they often yield as much, or more,
after-tax, than increasingly scarce current coupon paper. Taken
together these factors make a compelling case in favor of market
discount bonds, for investors who shunned them in the past.

The Increased Importance of Credit Analysis.

For roughly a decade - 1985-1994 - credit analysis
became virtually a "lost art" in the municipal bond markec. A
number of recene high-piofile events have thrust municipal
credit concems back inro the limelight. In the aggregate,
municipal credit quality is probably stable or improving
slightly, in the aftermath of a period of strong economic
growth. However, the disparity in credit quality may be
increasing, as a number of recent, well publicized events
suggest. These include:  problems that led to the bahkruplcy
filing in Orange Councy, California; b) the placement of New
York City on "Credit Watch" with negative implications by
Srandard and Poor's; c) the announcement of substantial
acculmulated deficits by Essex County, New Jersey and
Washington, D.C. As a consequence, we believe that credit
analysis will receive increasing attention among investors in
municipal bonds. Quality spreads may widen a bit; and
problem situations may erode more rapidly in the secondary
markec. As a consequence. Smith Barney is placing renewed
emphasis on providing information on municipal credit trends to
individual investors. A number of recent Municipal Bond Research
Reports reflect that trend:

State General Obligation Bonds: Rating Histories and
Outlooks            MU0346

Municipal Electric Utilities and Competition: An
Introduction            MU0345

New York City General Obligacion Bonds Placed on
Credit Watch            MU0348

Most recently, a Special Report entirled "Resource
Recovery Bonds: In the Dumps" MU0350 discusses  the problems
some issuers of these bonds are experiencing in the afrermath of
a Supreme Court decision which eliminated governmental control
over the flow of solid waste. Copies of the above may be
obtained from your Smith. Bamey Financial Consultant. In future
issues of MIM, we will expand upon these and other topics
related to credit qualiry.

For additional Market Information, Questions, etc go to the internet and
go to "omnifest.uwm.edu", register as a "visitor", then type 'go finance'
to read reports about the market, leave questions, etc

Mike Loewe