When asked why anybody would buy a corporate bond now that a taxable municipal bond alternative is available, Peter Coffin offered an inspired answer: “I don’t know.”
The founder of Breckinridge Capital Advisors in Boston sees Build America Bonds — the taxable munis created under the American Recovery and Reinvestment Act — as clear superiors to their corporate brethren.
Much of the buying in BABs so far has been what Coffin calls a trade: jumping in and hoping to jump out after some market appreciation.
He is exhorting his clients to try a different approach — committing long-term money to taxable munis as an important piece of their portfolios. They offer better yields and lower risk than the obvious alternative, he said.
“We’ve had some success attracting capital and getting clients to invest,” said Coffin, whose firm manages $10 billion in municipals, including $500 million in taxables. “They’re looking at it not just as a trade but as a standalone allocation that has merit as a fixed-income portfolio.”
The logic underpinning his thesis is simple: with less risk, BABs yield more than corporate bonds.
This apparent disconnect is the reason Coffin wonders why people buy corporate bonds.
The cumulative historic default rate through 2007 on muni credits rated AAA by Standard & Poor’s is zero. The default rate on double-A’s is also zero.
Not until the Standard & Poor’s single-A class is there any whiff of defaults, at a less-than-terrifying 0.23% rate. The default rate for corporate bonds at that Standard & Poor’s rating is 2.91%.
The default rate on munis rated junk by Standard & Poor’s is lower than the default rate on triple-B corporates.
The total default rate on munis rated by Standard & Poor’s is 0.29%. On corporates, it is almost 13%. Standard & Poor’s says it rates munis and corporates on the same scale.
Given this discrepancy in risk, the pricing on corporates and BABs is counterintuitive. BABs yield more.
One bond Coffin likes is a general obligation BAB from Ottawa County in Michigan. The county, which Moody’s Investors Service rates Aa1, sold $15.4 million in taxable debt this week to expand a water-supply facility.
The issue priced to yield 4.65% for the 2014 maturity, which is 206 basis points higher than the five-year Treasury note at that maturity. With the 35% federal debt service subsidy, the issuer’s cost on that maturity is about 3.02%.
Meanwhile, callable bonds issued by Procter & Gamble, which Moody’s rates Aa3, yielded about 3.5% at a 2014 maturity yesterday, according to Bloomberg LP.
That means an Ottawa County bond backed by the power of taxation yields 115 basis points more than a Procter & Gamble bond backed by the mercurial whims of consumers.
If Ottawa County’s spread over Treasuries is attractive, Coffin said,
its spread over corporates signals a clear buy.
“A lot of the high-grade corporates that would be of lesser quality are yielding considerably less” than taxable munis, he said. “That’s the beauty of this as a new asset class ... good yields and low risk.”
Coffin also pointed to a $16.3 million BAB issued by the Pendleton County School District in Kentucky, rated Aa3 by Moody’s. At a 2014 maturity, the issue yields 4%, or a spread of 50 basis points over P&G bonds.
Coffin, who was a portfolio manager at MFS Investment Management before founding Breckinridge in 1993, said clients for his taxable accounts include pension funds, endowments, and people with low tax rates.
He remains “very comfortable” with municipal credit risk, even in Michigan.
Coffin says he allows for the possibility of a crimp in credit quality, but points out that “crimped credit quality is a long way from default.”
“There’s just a huge gulf between a fiscal crisis and a real threat of default,” he said.