Municipal coffers are recovering, but many bond investors still favor revenue bonds, particularly the essential-purpose variety, over their general obligation brethren.
Revenue bonds are more plentiful than GOs. And in the case of essential-purpose revenue bonds, they offer more yield for not much more risk, investors say.
The shift in preferring revenue bonds, especially essential purpose, has been several years in the making, industry watchers say. It took the financial crisis and subsequent body blows to the funds of state and local governments for investors to really see the value in revenue bonds.
GOs, for their part, remain too large a part of the market for investors to ignore entirely. Still, investors see the storm clouds forming over many of the state and local governments that back them. Enormous pension obligations and substantial infrastructure needs, which will require heavy financing, reveal potential strains on state and local government budgets that give investors a measure of worry.
By comparison, essential-purpose revenue bonds, in general, “don’t have the same pension problems as state and local governments,” Michael Brooks, a senior portfolio manager of municipal investments at AllianceBernstein, told investors at a recent luncheon. “They don’t have to go to the voters to ask for a tax increase … They’re more stable in a down economic environment.”
Acceptance for revenue bonds has grown, and demand has increased accordingly, as more investors become comfortable with them, according to Sean Carney, BlackRock's muni strategist.
For one, they offer a decent reward for relatively little risk. Carney compared the Standard & Poor’s indexes for revenue bonds and GOs recently. The revenue index currently yields 3.65%, with a duration of 5.76 years. In 2012, the total return of the revenue bond index stood at 8.85%.
The yield for the Standard & Poor’s GO index measured 1.75%, with a duration of 4.93 years and a return of 5.85%.
“So, essentially, you accepted 300 basis points of outperformance for only taking on an additional three quarters of a year of duration,” Carney said.
BlackRock favors dedicated-tax bonds, a kind of revenue bond, because of their inherent strength and diversification capabilities. The bonds are secured by a direct revenue stream from governmental tax or fee revenues that are legally pledged for the benefit of the bondholder, he said. Such bonds have demonstrated long-term stability and resilience following periods of economic weakness, he added.
In addition, revenue bonds present an advantage by being more plentiful, Carney said. Over the past 10 years, GO volume has tended to hover around 35% of total issuance, Thomson Reuters numbers show. Thus, Carney added, they can be difficult to source.
“So, while investor demand has increased for our asset class, issuance has yet to increase to a level that satisfies on a regular basis,” he said. “Hence, people tend to go more toward what’s available— that being more revenue bonds.”
Stepping back, many GOs are similar in their makeup, in that they are backed by the full faith and credit, as well as taxing power, of the state or local government issuing the bonds. Revenue bonds, though, vary considerably, noted Ashton Goodfield, a managing director and portfolio manager at DWS Investments, Deutsche Investment Management Americas.
Some revenue bonds are safer bets than others, Goodfield said. Those include bonds that possess a dedicated revenue stream for an essential purpose, such as for water and sewer. Others draw funding for a purpose that investors wouldn’t typically consider essential, such as project revenue bonds for new construction, or long-term care facilities.
Investors at U.S. Bank Wealth Management have favored revenue bonds for the past several years, said Dan Heckman, a regional investment director and senior fixed-income strategist there. Essential-purpose revenue bonds provide better protection than GOs, he added.
That’s because a municipal electric utility would theoretically still run even if the municipality itself files for bankruptcy, Heckman said. So long as citizens keep their lights on, the utility will continue to collect that revenue — it cannot be redirected to pay off any other non-essential purpose for that specific issue.
“So, they can’t direct that money to help pay for GO debt, or any other debt that’s not for that sole purpose for that particular issuer,” Heckman explained. “People view them as a place they can go for a little higher level of safety and security.”
Both matter after the dark days of 2008 and 2009. To be sure, the financial ledgers at state and local governments have improved considerably since those times, but they are “not out of the woods yet,” AllianceBernstein’s Brooks said. For one, spending at state governments continues to climb — and consequently they’re giving less aid to local governments.
With both groups, Brooks said, rainy-day funds today are no longer as flush, pension funds are in worse shape, and the steps both took to balance their budgets, raise taxes, cut spending and staff, have been exhausted.
“The easy stuff has been plucked from that tree, the low-hanging fruit,” Brooks said. “It’s not going to be easy to go further than that. And as a result of that, we believe they’re more vulnerable. We’re not predicting a recession, but they’re more vulnerable.”
Beyond hefty obligations for pensions and other post-employment benefits, governments are going to have to deal with the growing need for infrastructure eventually, according to Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management. Charts tracking a measure of the average age of property plant and equipment show that state and local governments continue to see aging infrastructure, he said.
“Cities are watching their infrastructure get older,” Ciccarone said. “And there’s a probability that they’re going to need to borrow down the road here, as a result.”
When these factors are considered, AllianceBernstein underweights state and local GO bonds in its portfolios, Brooks told investors. As GOs comprise 35.5% of the muni market, AllianceBernstein stands at 23.6%, underweight by almost 12 percentage points.
Instead, it puts money into essential-purpose revenue bonds. While they represent about 22% of the market, he said, AllianceBernstein sits at 34.7%, or 12.6 percentage points overweight.