Experts Predict Active But Discriminating Buyers in 2008

With volatility and concerns that shook the municipal industry in 2007 — from Federal Reserve Board easings to deterioration in the subprime mortgage sector and its flow-on effects in the bond insurance market — retail investors are likely to be much more demanding and discriminating this year when it comes to the quality, yield, and structure of the bonds they add to their portfolio, according to several muni market specialists.

Despite ringing in the New Year with lower absolute rates and a steeper yield curve than a year ago, individual investors will be just as active in the market as they were in 2007 — but much more diligent in asking questions about a bond’s underlying quality than ever before in the wake of reviews of bond insurance company ratings. Retail investors — many of which are in a high income tax bracket and rely on municipal bonds to provide steady income and capital preservation — are expected to continue to seek shelter in the tax-exempt market amid continued volatility in other investment classes, sources said.

To get a broad range of opinions on some of the specific trends, behaviors, and strategies that retail investors are likely to display in 2008, The Bond Buyer interviewed six industry professionals and asked them to give their predictions.

BILL HORNBARGER, A.G. EDWARDS“Quality is the big watch word. Investors want to buy very high-quality investments and that doesn’t necessarily mean insured anymore in the municipal bond market,” says Bill Hornbarger, chief fixed-income strategist at A.G. Edwards & Sons Inc.

“Retail is now much more cognizant and concerned about the underlying ratings, and they want to know the worst-case scenario, and how a bond will trade if the insurer gets downgraded. That is the single most differentiating factor between 2007 and 2008.”“Although the municipal market is still relatively opaque to the individual investor, it is going to be more challenging for them — unless they are very sophisticated.”

“As we head into 2008, there won’t be a lot of upward pressure on bond yields, so that should make people more comfortable extending out on the curve. There will clearly be lower growth this year, easier Fed policy, and people are going to tend to gravitate toward safer investments.”

“There is a growing class of mass affluent investors with $500,000 to $2 million to invest that are in a high tax bracket, have accumulated assets, and want to protect those assets.”

“In general, fixed income will be a more popular investment this year because of concerns about the economy and the riskier markets. Most people look at bond yields and say they are low, so it becomes more important to look at relative value. There is nothing more attractive than municipals right now, even though absolute yields are low. Coupon to coupon, high-quality municipals are yielding more than Treasuries right now.”

RICK CALHOUN, CREWS & ASSOCIATES“The bond market has reeled from significant shocks in 2007 and investors tend to be more conservative in times of market turmoil,” says Rick Calhoun, first vice president of retail sales and trading at Crews & Associates. “Investor ‘due diligence’ will become part of the sales process and brokers should expect more questions about the municipal issuers’ purpose, security, insurance, and underlying ratings. Even long-time broker-client relationships will be subject to more disclosure. Investors also tend to save more during times of economic uncertainty, which will increase municipal demand.”

“Recent bond insurance downgrades and related subprime problems will alter behavior to some degree. If anything, the subprime mortgage crisis could push more investors toward municipals since hedge funds and other vehicles loaded with structured investment product lose favor.”“Bond insurance problems will also cause investors to more closely examine the issuer’s credit. Even though the default rate on essential public service bonds remains next to zero, that question will be asked more often than ever in 2008.”

“In spite of all the rhetoric on the presidential campaign trail, it’s unlikely that tax relief or tax reform is in the foreseeable future, therefore municipal demand should remain strong and investors more active.”

CHRIS MIER, LOOP CAPITAL“Despite low interest rates and bond insurer concerns, retail demand is likely to be roughly the same as last year because many of the alternative categories of investments appear to be less attractive than in 2007,” says Chris Mier, municipal strategist at Loop Capital Markets LLC.

“With the economy weakening, the stock market is likely to be under pressure most of the year. Real estate will continue to be unattractive from an investment standpoint — as it was in 2007 — and a slower economy may finally put an end to the rally in commodities prices. By default, municipals remain one of the preferred categories.”“With the Fed likely to continue to ease for at least the first half of 2008, the steepening yield curve and the low absolute levels — particularly at the front end of the curve — may convince retail to extend slightly to get more palatable yields.”

“The significance of the curve getting steeper is that retail will get a little more reward for extending a year or two and that may provide an incentive for wanting to extend.”

“In addition, with core personal consumption expenditures currently running at 2.2% on a year-over-year basis, we expect investors will also choose to move out on the curve a little in order to purchase after-inflation yields on municipal bonds that are meaningful.”

“Many market observers may cite the high ratio of municipals to Treasuries as a possible incentive which will boost municipal retail demand [in 2008]. While ratios are very high, I tend to believe that retail responds a little more to the absolute level of rates than to the relative pricing of different categories of fixed-income investments.”

JOHN MOUSSEAU, CUMBERLAND“One thing that retail investors will now have foremost in their minds is the value of diversification — among insurers, credits, and states. They are going to be more careful regarding credit and know more of what they are buying. I think that is one reason why you have seen outflows from bond funds in the past few weeks, even though the market is doing pretty well,” says John Mousseau, senior portfolio manager at Cumberland Advisors.

“I think some of the non-high-yield fund redemption is a result of investors concerned about the bond insurers and wanting to have a firmer handle on what is going on. We will likely see that money reinvested in the form of private accounts.”“As the front edge of the baby boom hits retirement age this year, fixed income presumably will increase as an emphasized asset class. This will result in different strategies — laddered portfolios for some, total return portfolios for others. The current steepening going on in the municipal yield curve will send others further out on the curve to seek incremental yield and we will gain more sponsorship for the longer end of the market.”

KEN MEISELMAN, J.B. HANAUER“We expect buyers to be on the longer end of the market due to the steepness of the curve and extremely positive ratios compared to Treasuries,” says Ken Meiselman, executive vice president of trading at J.B. Hanauer & Co.

“Our clients are income-oriented, so they are already getting opportunities now that were not available 12 months ago when there was a flat yield curve and everyone was sitting in cash. That is not the case anymore.”“We are seeing different habits already. Investors are buying triple-B bonds, like pollution-control revenue bonds, hospitals, and Puerto Rico GO bonds of late, because they are now more compensated versus a year ago compared to certain triple-A bonds because the spreads are wider than a year ago.”

“Because of all the uncertainty with the bond insurers, we have clients asking, ‘What’s the underlying credit?’ and you never had those questions so much before. That is a new trend. They are checking into the underlying credit instead of just accepting the insurance.”

“Some people are passing on bonds they would not have passed on six months ago, and that is creating wider spreads on some bonds and creating opportunities for others who are looking for the yield differential that is available for taking some risks.”

“If equities stay volatile and sloppy, money always runs to the municipal bond market.”

BILL MASON, DAVID LERNER “The flight to quality in today’s environment has led retail to the doorstep of municipal bonds,” says Bill Mason, senior vice president of retail trading and underwriting at David Lerner & Associates. “Other investment options have been marginalized, such as high commodity prices, gold approaching $900 an ounce, a volatile stock market, a declining real estate market, and Treasuries being rich to municipals.”

“Baby boomers are entering a more conservative part of their investment life. We are watching an investor with a previously less conservative outlook come of age. They saw a volatile stock market decimate their 401Ks and they are watching the value of their homes go down. Looking forward, the likelihood is that they will be trying to preserve assets and reap the benefits of solid, steady, and conservative growth.”“With today’s environment, the question isn’t ‘why should you buy municipals,’ the question is ‘why wouldn’t you buy municipals?’ Once you weigh risk, return, and the quest for investment peace of mind, municipals are by far the best investment available for retail investors.”

“The bond insurance problems so far have been minimal for our clients. We have always sold bonds with strong underlying credits and strong name recognition.”