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As I attempted in the first installment, I offer a high level overview to generalize my view on the credit quality of a vast expanse of states, cities and local issuers of municipal bonds. I believe ratings do matter because, not only do they represent a measure of differentiation and separation of value for some 60,000 issuers, but in the long run, they may serve as an affirmation of the soundness and strength of tax-exempt investments. Part 1 summarized ratings at the state level. This installment seeks to do the same, but for the broader expanse of issuers. While the downgrades of 2012 outpaced the upgrades by nearly a 5 to 1 margin, this is a recent phenomenon that defines the post-recession years (2009 – 2012). Prior years, going back to 1989, evidenced year-over-year upgrades that consistently outpaced downgrades.
In a recent report from Moody’s, the attention grabbing headline was that in 2012, “a record of $311 billion of public debt” was downgraded, surpassing the prior record of $194 billion in 2009. I believe that a better metric, however, is assessing the ratings actions that were taken during the year rather than the representative market value. Why? Because if the ratings of one or two very large issuers change, they may skew the overall results. For example, in the fourth quarter of 2012 almost 50% of the downgrades by market value alone were attributable to Puerto Rico issuers.
In my view, the key figures are: (1) in 2012, when more than 80% of all ratings changes were downgrades, Moody’s only changed ratings on 1,000 of 14,000 issuers it rates; and (2) the number of upgrades in 2012 increased by 50% (187/125) over 2011. By that representation, some municipal bond issuers were able to improve their financial positioning while the great majority (some 13,000) was able to maintain its ratings status. I am not diminishing the significance of the trend, but do think it important to highlight that local governments appear to have acted responsibly and with fiscal restraint, and I believe that we have the potential to continue to benefit in the context of broadly diversified portfolio structures, i.e., ETFs, from this generally high-quality asset class.
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Municipal bonds are subject to risks related to litigation, legislation, political change, conditions in underlying sectors or in local business communities and economies, bankruptcy or other changes in the issuer’s financial condition, and/or the discontinuance of taxes supporting the project or assets or the inability to collect revenues for the project or from the assets. Bonds and bond funds will decrease in value as interest rates rise. Additional risks include credit, interest rate, call, reinvestment, tax, market and lease obligation risk. High-yield municipal bonds are subject to greater risk of loss of income and principal than higher-rated securities, and are likely to be more sensitive to adverse economic changes or individual municipal developments than those of higher-rated securities. Municipal bonds may be less liquid than taxable bonds.
The income generated from some types of municipal bonds may be subject to state and local taxes as well as to federal taxes on capital gains and may also be subject to alternative minimum tax.
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