12/23/02

Few investors would disagree that it has been a difficult year for credit quality in the corporate arena. Meanwhile, little attention had been paid, until now, to the growing evidence that many states and municipalities now exhibit the lagging stresses of a slowing economy. As for the economy, the timeline and trajectory of its recovery remains the subject of considerable debate. Accordingly, the question of strategy has become paramount for individual investors.

That being said, we often get the question “Should I be buying stocks or bonds right now?” Without the benefit of a well-functioning crystal ball, the prudent answer may be both…on a highly selective basis. This topic will be revisited later in the text.

With regard to credit quality in a municipal bond portfolio, it is worth noting that the marketplace gets very little press coverage (usually) because changes in credit tend to occur rather gradually. To be sure, high profile ratings actions (like Standard & Poor’s downgrade last week of the State of California’s general obligation debt rating to “A” from “A+”) warrant attention. But the impact of such events may be surprisingly muted for individual investors who buy & hold high quality bonds until their final maturity. Market forces will, of course, cause the valuations of all securities to fluctuate and negative headlines can be daunting for investors to digest, but investors should always be mindful of their time horizons and investment goals.

Further, the realization of adverse ratings agency outlooks (and actions) for many states and their constituent municipalities now coming to the fore has already been processed by many market participants for the majority of 2002. Indeed, Moody’s Investors Service had changed the outlooks of 15 states to negative by August 2002, continuing a process begun in December 2001. While the decision to hold, sell, or buy during credit downturns should be discussed with an individual investor’s Financial Advisor, “knee-jerk” reactions are rarely recommended. Looking forward, ratings volatility can produce both anxiety for current bondholders and opportunity for potential buyers seeking favorable entry points, depending on the risk tolerance of both groups.

Getting back to the macro-picture, the counter-cyclical nature of municipal bonds typically dictates that yields will rise (and prices decline) during periods of economic strength. Conversely, equity valuations often rise during such periods. For individual investors, timing the market and chasing yield have their pitfalls. Bearing this in mind, the combination of stocks and bonds holds many benefits, especially when a clear economic path appears elusive. Pockets of value (equities or bonds) can often be obtained while the overall sectors are under pressure. The balance of such a combination often varies from investor to investor on an individual needs basis.

For an individual investor whose income tax status supports the purchase of municipal bonds, the maintenance of a high quality portfolio is often a comfort during periods of economic duress (and presumably lower equity valuations) because of tax-exempt interest income and price appreciation (if applicable). But what if rates rise? In this climate, most fixed income investments will experience price declines. But the advent of such an environment may not be quite as dire as media reports may suggest.

The majority of individual investors who purchase individual municipal bonds (as opposed to funds) typically seek to maintain the tax-exempt fixed income that these vehicles provide. Conversely, professional money managers often will buy and sell on a total return basis. Although this is relatively basic concept, it is one that is often lost when reading headlines (usually negative) regarding the overall market or perhaps individual municipal issuers. There are a few actions individual bondholders can take to prepare for and react to rising interest rates.

Building a laddered portfolio is a common choice to prepare for the possibility of higher yields. By purchasing sequential maturities (as opposed to choosing a lump sum in one maturity), investors can lock in the income of the longer dated maturities while enjoying the reinvestment opportunities of the shorter ones. A focus on premium priced bonds (high quality and high coupon) can also be part of a defensive strategy against rising interest rates, as such bonds commonly hold their value longer due to superior income generation.

Individual investors holding individual bonds can also sell their bonds (realizing their paper losses) and use the proceeds to purchase another bond unique to issuer name and maturity, should rates rise. The loss can then be applied (up to $3,000) against gains in other sectors of the portfolio, with excess losses carried forth for future years. This process, commonly referred to as a tax swap, is witnessed most often late in the year after rates have risen significantly.

On a final note, short-term events often hold limited applicability for long-term investment parameters. While these events certainly should be monitored, the most obvious choices are not always the best. The bond markets, including municipals, are awash in shades of gray…a closer inspection typically works best.

The Municipal Research Department would like to take this opportunity to wish you and yours a happy and healthy holiday season and a joyous New Year.