Investors overlooking muni-bonds

(February 2008) Everyone knows that government savings bonds are a safe way to invest, but they’re not much fun when it comes to returns. So some investors who want the security of a federal or provincial bond but like a bit more kick in the return are turning to often overlooked municipal bonds.

Muni-bonds are issued by cities to fund capital expenditures — Toronto nets $500 million a year for the Toronto Transit Commission and road upkeep — and, for the most part, have a similar rating to provincial bonds. They are slightly riskier than their federal counterpart, but it’s unlikely the City of Vancouver will default on its commitments, so the risk is generally regarded as minimal. Then why is this debt instrument still the ugly duckling of bonds?

“Most of the issues come from small cities, municipalities or local governments,” says Guy Le Blanc, portfolio manager with Bissett Asset Management. “It’s small cities, with small projects and small issues.”

In these small cities, issuance is often more sporadic than in major cities. Le Blanc says some towns offer multiple issues with different maturity dates, or they may sell only $1 million worth of bonds — too small for any serious investing.

As well, Canadians don’t get the same tax breaks that U.S. muni-bond holders do. In the States, Americans don’t pay federal tax and in many cases avoid local and state taxes as well. That’s helped these bonds become wildly popular down south, while capital gains possibilities have kept the popularity of munis stagnant in Canada.

But the main deterrent for investors is that municipal bonds have to be held until maturity to work; otherwise the client risks losing money. “There is no secondary market on these issues,” says Le Blanc, whose Bissett Bond Fund has 2.38% invested in munis. “For someone who wants to buy and hold, that’s fine, but that’s money you may have to trade … and if you want to move it into a secondary market, you don’t know what you’re going to get pricing-wise.”

“It’s not like a savings bond,” says Martin Willschick, manager of capital markets for the City of Toronto. “The price fluctuates according to the market, so that might be why it’s not as popular.”

The price of municipal bonds is largely determined by interest rates. When rates go up, bond prices go down and vice versa. “There could be a capital loss if rates rise,” says Willschick. “A lot of people aren’t used to that type of situation. They feel they want it to be like Canada provincial savings bonds, which would be redeemable at par all the time.”

Surprisingly, Willschick says, most of the investors who buy muni-bonds aren’t of the buy-and-hold variety, but that’s probably because 70% of Toronto’s municipal bond investors are institutional. In general, he finds that most people would rather move their money around than hold a bond until maturity. “If there is a retail investor, they may be in it for a while, but then the broker will suggest selling now. You’ll get a capital gain and then put it into something else, and it goes back and forth. It’s unusual that people hold investments of this nature to maturity.”

Joe Lee, vice-president of Oakville-based Campbell & Lee Investment Management, used to be one of those retail advisors who offered his clients the chance to invest in municipal bonds. But it’s been nearly a decade since he bought his last City of Toronto bond. “I don’t think you’re adequately rewarded for the credit you’re getting,” he says. “You have to rank credits in some order. You give up some sort of yield when you go up the chain, and pick up some yield when you go down. It’s a question of how much you want to give.”

But Lee acknowledges that there are a number of benefits to municipal bonds. He used to use the instrument as a way to diversify his portfolio. He says the best way to maximize the investment’s potential is by including muni-bonds among other government-issued bonds. “Each gives you more yield than the previous one as you go down the ladder,” he explains.

If your client wants municipal bonds, Le Blanc says big issuers, like the Municipal Finance Authority of British Columbia, which sells bonds on behalf of a number of B.C. cities, are a safe bet. “The spread is related to the overall economy of British Columbia,” he says. “There’s no support from the province, but there’s an understanding that the province could step up if there was a problem.”

Le Blanc also buys municipal bonds from the Alberta Capital Finance Authority. He says a lot of people think that cities in Alberta don’t need to issue debt, but with rising infrastructure needs and a booming population, that’s not the case.

Alberta securities are AAA-rated, which, says Le Blanc, is better than the province of Ontario. They also have issues in the hundreds of millions of dollars, and the spread is comparable to what Ontario offers. “It’s a good issuance,” he says. “They know what they’re doing. They’re watching the market and have big liquidity issuances.”

As for Toronto, Le Blanc usually stays away from its municipal bonds. He says pricing is a big reason for not buying. Toronto bonds start at $100 but currently range anywhere from $101 to $112. “We haven’t purchased them in a long time,” he explains. “They’re the type of issuer we’d look at, but their bonds coming to the market are too expensive.”

Despite municipal bonds’ being the least popular type of government issuance, these offerings are vital for cities. In Toronto, about half of the city’s debt issuance goes to fund transit, while other funding is used for roads and other infrastructure needs. While the city does only about two issues a year, totalling $500 million (it has 46 issues in the market right now), Willschick says it could probably get away with issuing $800 million worth of bonds.

“There would be sufficient demand in the market for the city to issue $800 million in debt in one year, but our debt issuance syndicate would not advise increasing the amount,” says Willschick. “We could find enough investor demand [to issue more than that], but the interest rate that we would have to offer would probably have to increase.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(02/13/08)

Bryan Borzykowski