1861 Capital: Municipal Bond Investors Have Claims in Capital Structure: Losses and Gains to Bondholders.

Securities and Exchange Commission chairman Mary Schapiro told lawmakers Wednesday that the agency is considering whether to exempt all muni issuers, not just states, counties and cities, from federal regulators’ joint Volcker rule proposal.

The remarks, in testimony before the House Financial Services Committee, came as dealer and industry groups criticized the plan, released in November by the SEC and banking regulators. The groups warn the proposal would bifurcate the municipal market because it exempts bonds issued by states, counties, cities and other units of government, but not bonds issued by turnpike authorities, water and sewer districts, school districts and housing authorities.

The Volcker rule, mandated by the Dodd-Frank act, generally would prohibit banks from trading on a proprietary basis and restrict their investments in hedge funds and private entities.

1861 Capital Treasury Bonds, A Good Investment

The municipal market is a complex market and requires expertise. It has been said that the Treasury market has the yield curve, the mortgage market adds optionality, the corporate market adds credit, and the municipal market adds politics to all these other considerations. The municipal market is very driven by supply and demand, which can be driven by legislation. Many taxable portfolio managers have lost money “crossing-over” to the municipal market without a thorough understanding of this market. Generally, taxable portfolio managers do not pay attention to taxation in their trading nor to the coupon on their bonds. Understanding the structure (i.e. coupon, maturity, call) is critical to portfolio construction.

Municipal bonds are genrally backed by the full faith and credit of the municipality in the case of a general obligation bond, in the case of revenue bonds, backed by defined revenues or fees. Think of a toll road. Coupons are paid semi-annually. They are typically exempt from federal taxation, and in many cases state and local taxes. Bondholders often have senior claims on revenue streams making losses historically remote. The senior claim feature of many municipal revenue bonds make them unique to many fixed income asset classes. Hence, if investors look at the losses associated with owning municipal bonds, they are low compared to many other asset classes. Standard and Poors and Moods have written extensively about this. At the same time, investor gains, can be limited to receiving par back at maturity.