Saturday, January 5, 2008

Generating Yield – Muni Bond and REITs

Many investors focus on traditional yield-generating instruments such as muni-bonds and REITs when seeking income. Both of these investments have taken significant hits in the recent market turmoil and there is increasing concern over their expected performance in 2008. The underlying economic conditions that have caused their recent dismal performance during the past year have not changed, and investors should be aware of the risks facing these income vehicles.

At first glance the beaten-down municipal bond sector appears to be a solid alternative for income seekers. Proponents such as analysts from Nuveen have talked up the muni market recently stating that there should be a solid recovery into 2008. Others doubt this sunny outlook.

Due to their tax-exempt status, muni bonds usually have lower yields than comparable U.S. Treasuries. However due to the price dive in the muni sector, the yields are now in the same region. The typical triple-A rated 10-year muni bond is yielding 3.9%, while comparable 10-year Treasuries are yielding 4.2%. That means an investor in the 33% federal tax bracket would have to earn more than 5.8% in a taxable bond to beat the muni. Similarly with 30-year bonds, the muni (4.7%) and Treasury yields (4.6%) are virtually the same. To outperform the 4.7% muni, an investor would have to get more than 7% in a taxable bond.

Does this make muni-bonds a good income oriented investment for 2008 – not necessarily. The muni market is fraught with risk and the pricing is merely a reflection of the deteriorating situation. Traditionally muni bonds are thought of as safe because communities can normally increase taxes to cover payments, and local governments tend not to go bankrupt. These simple truths may no longer hold water in some instances, nor have they held true in the past; one example is New York City's fiscal problems of the 1970s and another is Orange County’s (CA) earlier bankruptcy situation.

The issues facing munis were discussed earlier in “ The Muni Bond dilemma". In summary, there are several notable risks facing munis which include:

  • The pension payment crisis unfolding in many states and communities.
  • Increasing budget shortfalls for basic infrastructure projects.
  • Reduced tax collection due to foreclosures.
  • Rejection of tax increases by voters in communities facing economic stress.
  • Probable insolvency of bond insurance firms (ACA Capital, MBIA, Ambac Financial)
  • Falling revenue from community projects.
  • Impending court rulings about state tax interest deductibility.
  • Community investment fund losses (see Will State SIV Funds bankrupt local communities?).
  • An increasing number of bond downgrades from rating agencies.

For those investors evaluating new municipal bond investments, the focus should be on quality and the general financial strength of the backing community. Avoid bonds from areas with high levels of foreclosures, projects with single sources of revenue (theaters, stadiums, etc.), and those insured by agencies on the edge of failure.

REITs are in no better shape. The average apartment REIT was down 27% during 2007. Despite the expectation that many people will move from owning homes to renting, apartment REITs are normally the worst performers during a recession.

Many other REIT segments have not fared much better. The outlook for the coming year shows no improvement. Hotel REITs such as Sunstone Hotel Investors Inc. (SHO) have recently endured down-grades and sunk to new lows. Office and Industrial REITs have demonstrated slowing growth expectations; capitalization leaders such as Boston Properties Inc. (BXP) are down over 24% over the past year. Retail property owners are down over 20%, the Simon Property Group Inc. (SPG) hit new lows recently. While the drop in price makes the valuation on some REITs appear attractive, there is an increasing risk that the dividend payouts may be cut.

One bright spot is Health Care REITs. This REIT sector has more upbeat outlook than others even in the face of a slowing economy. There is a growing demand for health care office space and the lending credit crunch has not slowed build-out. An article from December outlined some of the leaders - Sector Glance: Health Care REITs Rise.

Another sub-sector of REITs that normally holds up in down markets is apartments for college students. The growing demand for college housing is likely not to be impacted by the economic cycle. One REIT focused on this segment is Education Realty Trust (EDR) with a 7.60% yield.

In summary, Muni-Bonds and REITs have numerous headwinds looking forward into 2008. Other yield oriented investments in the energy and natural resource sectors may offer better performance with lower economic risk (see In Search of Yield) Investors should carefully evaluate the potential risks before allocating money to Muni and REIT investments over the upcoming months.

Disclosure: The author does not have a position in any of the income equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.