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3 Ways to Boost Your Muni Bond Due Diligence

3 Ways to Boost Your Muni Bond Due Diligence

As an investment portfolio manager, I recall the “good old days” when muni bond due diligence was so much easier. You made a few calls to the bond dealers and maybe checked out available bonds on the Bloomberg terminal.  Then you looked for bonds with decent credit ratings. Or better still, you sought out muni bonds that were insured.  By making a promise to back the bond issuer in the event of a default, the monoline insurance companies were able to deliver a solid AAA credit rating.  Once you found the bonds that worked, you executed your purchase trades and moved on to other things.

Boy, how times have changed.  In 2008, insurance companies such as AMBAC, MBIA, and FGIC got into financial trouble due to bad bets made on mortgage-backed and asset-backed securities.  This ultimately culminated in the monoline insurers being downgraded by rating agencies such as Standard & Poors, Moody’s, and Fitch. This resulted in the loss of the insurance companies’ coveted AAA status.  While the credit ratings of municipal bond issuers were still considered acceptable and default risk remained extremely low overall, the loss of the “easy AAA” made it a little more difficult for bond investors.

The Dodd-Frank Effect

Things got tougher in 2012 when rules stemming from the Dodd-Frank Act went into effect.  As described by the Office of the Comptroller of the Currency (OCC), Section 939A of Dodd-Frank amended the definition of “investment grade bonds” to eliminate any reference to agency credit ratings.  According to the OCC guidelines (which were adopted by other regulatory agencies):

“Under the revised regulations, to determine whether a security is “investment grade,” banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations.”

The guidelines also require financial institutions to “supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution’s risk profile and for the size and complexity of the instrument.”  In short, this means that banks cannot point exclusively to bond credit ratings to justify a bond’s creditworthiness. They need to have a process in place to demonstrate adequate due diligence of their bond purchases.

Ways to Enhance Your Muni Due Diligence

While setting up a system to meet the rules does take some work, it is not difficult.  Here are three things you can do to provide a boost to your due diligence efforts:

1. Maintain document files for bond issuers

Keeping the official statement (OS) and the continuing disclosures from the issuers of bonds you own is a good start.  Bond dealers should able to provide these if you ask.  You can also get PDF copies of the documents online in some cases (see below).  If you have access to a Bloomberg terminal, you can also download issuer documentation.

2. Ask your bond dealers about available due diligence information

Many bond dealers can provide due diligence “snapshots” of municipal bond issuers.  When you are evaluating a municipal bond for purchase, ask them for a copy of any information they have available.

3. Use third-party online resources

In addition to materials available from your bond dealer, you can obtain useful information from online sources.  Some of these include:

EMMA – The Municipal Securities Rulemaking Board’s (MSRB) site, which is a repository of municipal bond documentation available in PDF format (you can learn more about EMMA on my resources page)

City-Data – Demographic and economic data on individual towns and school districts

State & Local Government on the Net – An online directory of state, county, and local government websites

MuniNet – A compilation of reports, news, and data pertaining to municipal governments

Your muni bond due diligence efforts are a necessary part of the process, but it does not need to be an obstacle.  Make these three steps part of your routine. Doing so will help you gain a better understanding of your portfolio holdings while providing a level of bond analysis that the regulatory guidance suggests.