Sponsored Content - American Century Investments
Steven Permut
Senior Vice President
Senior Portfolio Manager
David Moore
Vice President
Director of Municipal
Credit Research
Joseph Gotelli
Vice President
Portfolio Manager
A January 2011 Investment Viewpoints offered a municipal bond (muni) market Q&A with Steven Permut, senior vice president and senior portfolio manager in charge of American Century Investments’ muni portfolio management and research teams. His Q&A focused on the muni market’s sell-off in the fourth quarter of 2010, including its causes and effects. It also sorted the market’s long-term fundamental strengths and benefits from the near-term media headlines that triggered the sell-off.
In this April 2011 muni update, we build upon and update that discussion, with the assistance, again, of Mr. Permut, plus his muni team colleagues David Moore, vice president and director of muni credit research, and Joseph Gotelli, vice president and muni portfolio manager.
Much attention has been focused on the muni market’s struggles since last summer and the massive muni fund redemptions since then (over $40 billion, but decelerating since January). Somewhat surprisingly, the market rallied, beginning in mid-January. How did the rally start?
It shows that not all muni demand comes from high-net-worth individuals and muni funds (though they do own approximately 70% of the almost $3 trillion market). The rally catalyst was a combination of factors. As muni yields climbed and prices fell during the big muni market sell-off from August 25, 2010, to January 14, 2011 (when the benchmark Barclays Capital Municipal Bond Index declined 6.34%), the following changes occurred:
- Muni yields and prices became increasingly attractive—especially compared with taxable U.S. government bond yields and prices—to a widening range of relatively sophisticated, total return-driven (as opposed to tax-exempt income-driven) investors.
- Muni issuance declined dramatically, creating improved supply/demand conditions.
- The broad taxable U.S. bond market also rallied, starting February 11, adding some momentum and support to the muni rally.
- Respected, experienced muni investors and credit analysts published counterarguments to the more sensational claims and projections that had helped trigger the muni market turmoil.
Can you elaborate on each of those points, starting with increased non-traditional muni demand as the market sold off?
the diverse needs of your clients.
While high-net-worth individual investors have generally reduced their muni holdings since last summer, so-called “crossover buyers”—including hedge funds, pension funds, insurance companies, and taxable bond portfolio managers (including those at PIMCO and American Century Investments)—have increased theirs.
These buyers were drawn by tax-exempt muni yields that approached and exceeded 100% of Treasury yields, and by the prospect of potential capital appreciation, should prices rebound. These investors bought into the concept that the falling muni “tide” after the wave of dramatic media headlines dropped all muni “boats” indiscriminately, including many sound bonds that remained truly “sea-worthy.”
Indiscriminate, sweeping characterizations don’t do justice to this market. The municipal credit market is very fragmented, featuring approximately 55,000 issuers with unique credit characteristics, which reduces the risk of a systematic wave of defaults. Furthermore, the market is composed of a variety of sectors—including state and local government general obligation bonds, public power, water/sewer, airports, toll roads, and hospitals—all of which have different credit characteristics and sensitivities. For example, the economy plays a bigger role in the credit quality of a state or local government than with a public power or water/sewer credit.
If muni investors want some insulation from economic or municipal budget risk, we suggest investments in high-quality essential service bonds such as water/sewer, public power, higher education, or transportation.
What caused muni issuance to decline?
Issuance plunged during the first quarter of 2011, to levels not seen since 2000, according to Thomson Reuters. Lower issuance so far this year has been attributed to a combination of:
- Accelerated issuance at the end of last year to utilize Build America Bonds program government subsidies before they expired (which shifted some issuance to last year that might otherwise have taken place this year).
- The prevalent atmosphere of municipal budget austerity this year, fueling a reluctance to add more debt to municipal budgets.
How did the broad taxable bond market come to the muni market’s assistance?
A broad taxable bond market turnaround beginning in February helped the muni market’s rebound earlier this year. By the third week of February, concerns about climbing energy prices amid Middle East political turmoil helped trigger equity market turmoil and another wave of “safe-haven” buying of U.S. bonds, including munis.
What were the counterarguments to the sensationalist claims that triggered the record muni fund redemptions in December and January?
Perhaps the most notorious claim was offered on a December 2010 segment of “60 Minutes” by a well-known financial industry analyst who is relatively new to the muni market. She was speaking about local (city and county) munis: “You could see 50 to 100 sizeable muni defaults. This will amount to hundreds of billions of dollars’ worth of defaults.”
Most active, experienced muni market participants and analysts, including our team, agree that while muni credit remains under pressure and there will likely be an increase in defaults this year, it won’t be on that scale. We believe in the resiliency of muni credit. We think we will see isolated, not widespread, cases of defaults triggered by various combinations of recession- and post-recession-caused financial shortfalls and fiscal mismanagement.
Why do we believe in the resiliency of muni credit? First of all, we think those projected default numbers reflect an absolutely worst case scenario that’s highly unlikely to happen—by our estimates, the entire list of the 100 largest county and city issuers in the U.S. would have to default to produce $100 billion of defaults.
Secondly, while the sensationalists have focused on municipal liabilities, we believe they have largely underestimated municipal assets and income sources. Local muni issuers have many fiscal strategies and resources available to them, particularly their ability to raise taxes and cut expenses. Municipalities also have assets that do not appear on their books—such as airports and toll roads—that they can monetize to balance budgets.
So far, on the expense-cutting side of the budget ledger, municipalities have lagged the private sector in terms of layoffs, but we believe we will see municipal layoffs—as well as other austerity measures such as renegotiated pension and other compensation agreements with state employees and other unionized workers—increase this year. For example, look at the pension reform struggles being waged between state governments and employee unions in Wisconsin and Ohio, which were among the states that did not adopt reforms last year (18 did).
It’s also worth noting that while forecasted pension liabilities are significant, they are not immediately impending, which provides municipalities time to address these issues. Imposing shared health care costs, pushing back the retirement age and converting to participation-style pension plans should enable state and local governments to improve their financial condition.
What about the “major collapse in the municipal bond market” claim?
Another claim that attracted attention was the February cover story of a major financial publication that featured a successful (though lacking in muni experience) bond fund manager who foresaw “a major collapse in the municipal-bond market, beyond the declines to date, given the parlous condition of both state and local government finances,” quoting the article.
In the article, he says what makes the muni market particularly vulnerable is “its weak psychological underpinnings”—wealthy individuals who buy the bonds purely because of their tax advantages and have little fundamental knowledge of the muni market. These investors will thus be prone to panic in the face of surging defaults and “muni bonds will plummet, in part because other sorts of investors tend not to step in.”
There’s much in those statements that’s debatable, but we especially disagree with the part that other investors will not step in to buy on weakness. That’s been disproved already by what’s happened since January. We—like fixed income teams at other investment management companies—have used the decline in muni values to purchase them in our taxable bond portfolios. Also, as we outlined earlier, many other crossover buyers attracted by the values and yields available in munis have stepped in, which has helped stabilize the market.
Can the muni market’s recent relative stability be sustained? Is the worst of the credit-related and headline risk-related muni market volatility over?
To the extent that these risks are economic-related, we believe the worst is over, provided the U.S. economy sustains its recovery. We think that should happen, despite recent headwinds. We believe we’ve been through the worst of the economic pressures, though those pressures will likely continue as long as the U.S. housing market remains depressed and unemployment remains high. That’s why we continue to favor high-quality issuers and essential service bonds in the muni portfolios we manage.
Our Macro Strategy Team’s analysis indicates that we are now in a subpar but sustainable economic recovery, a pattern of 2-4% real economic growth that should continue to boost tax revenues (which began climbing again last year) and help municipal credit quality improve. Corporate profits are growing, the manufacturing sector is expanding, and the labor market is improving, all of which are good signs.
The biggest risk is an economic setback this summer after the Federal Reserve’s second round of quantitative easing ends, and if the headwinds encountered so far this year (including the Japanese earthquake and nuclear crisis, political turmoil in the Middle East and North Africa, higher energy prices, domestic budget shortfalls, and European debt problems) manage to derail the relatively fragile recovery. So we’re being guardedly optimistic about the economic outlook while identifying the potential pitfalls.
Does an improving economy mean reduced muni market volatility?
In the longer term that’s likely—particularly credit-related volatility—but not necessarily in the short term. Headline risk could continue to influence retail investor behavior this year. And that influence can be sizeable, as we’ve seen, because of the relatively smaller size and lower liquidity of the muni market compared with others. It’s a relatively small, illiquid, inefficient market that can turn on a dime, both positively and negatively, as we’ve seen over the past 12 months.
But even when there’s near-term volatility—whether it’s caused by default-related headline risk, inflation fears, or rising interest rates (all of which are possible in coming months)—the muni market, like bond markets in general, is generally resilient. That’s because of its income component, which smoothes out returns over time and helps investors bounce back from losses.
For example, look at the last three-plus years (since December 2007), arguably the most turbulent period in muni market history due to the historic sell-offs from September to October 2008 and more recently from August 2010 to January 2011. Yet, the total annualized return for the Barclay’s Capital Municipal Bond Index from December 31, 2007, to March 31, 2011, was +3.92%! And that’s a non-tax-adjusted return, without taking into account any tax-savings considerations for tax-sensitive high-net-worth investors. The annualized price return was negative (-0.90%), but the high annualized coupon return (+4.73%, with reinvestment) more than compensated. That’s a key reason why, on a risk-adjusted return basis, munis continue to compare very favorably with other asset classes.
You’ve presented a lot of information here. How would you summarize it?
Let’s look again at the big picture. U.S. economic strength is improving, but municipal credit, though resilient, remains under pressure, which will continue in coming months until the U.S. housing and labor markets improve, bolstering the tax base, and until municipalities finish making necessary revenue and spending adjustments. Though under pressure, muni credit remains mostly fundamentally sound, as it has historically after economic downturns, and it’s very diverse—you can’t paint it with one broad negative brush.
Price-wise, the market has stabilized this year as issuance declined and buying opportunities opened for a broader range of more sophisticated investors. However, muni prices remain at risk of further volatility due to headline risk and selling by retail investors. We anticipate there will be more local government downgrades and defaults going forward that could trigger retail investor reactions, but they will not be nearly as widespread as suggested by sensational media reports, especially for traditional municipal credits such as high-quality general obligation and essential service revenue bonds.
We suggest selectively adding exposure to those sectors of the muni market through professionally managed portfolios to take advantage of relative value opportunities, and to maintain these positions through any coming headline-related volatility this year.
Remember, high-net-worth individuals can still earn attractive tax-free income from munis. And munis typically outperform Treasuries in rising interest rate/improving economic environments. For tax-sensitive investors, we suggest looking at periods of muni market volatility this year as potential long-term investment opportunities.
This information is for educational purposes only and is not intended as investment advice. The opinions expressed are those of the fund manager and are no guarantee of the future performance of any American Century Investments portfolio.
Generally, as interest rates rise, bond prices fall. Investment income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax (AMT). Capital gains are not exempt from state and federal income tax.
The Barclays Capital Municipal Bond Index is a market value-weighted index designed for the long-term tax-exempt bond market. It is not an investment product available for purchase.
©2011 American Century Proprietary Holdings, Inc. All rights reserved.
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