Many still offer high-quality and compelling tax advantages
Sponsored Content – American Century Investments
April 6, 2010
You and your clients often sift through competing, complicated information in the course of making investment decisions. That’s certainly true in the municipal bond market today.
On the one hand, municipals enjoyed record outperformance compared with Treasury bonds in 2009. On the other hand, budget challenges facing state and local governments have never been greater.
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Joseph Gotelli, municipal bond portfolio manager at American Century Investments®, urges investors to consider municipals’ enduring features. Conflicting news and views on the municipal market should not obscure the fact that many municipal bonds remain high-quality investments with compelling tax advantages.
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Investors in higher tax brackets or living in high-tax states, such as California and New York, can receive a significant boost to income thanks to the bonds’ favorable tax treatment. “As the federal government turns its attention to addressing massive debts, higher taxes seem a virtual certainty,” says Gotelli. “State and local governments are also likely to seek additional tax revenues at some point.”
Market review: Record Outperformance
Municipal bonds have performed very well since late 2008, when yields reached record highs relative to Treasury bonds. Such attractive tax-free yields did not escape notice, and demand for municipal bonds ran at a record pace through the third quarter of 2009.
At the same time, tax-exempt municipal bond supply was sharply curtailed by the Build
America Bond program, a federal government program intended to lower borrowing costs and improve access to capital for municipalities. That program took many newly issued bonds out of the tax-exempt market and put them in the taxable universe. Record demand and limited supply combined to send municipal bond yields to 40-year lows in September. Put it all together, and 2009 was the best year ever for municipal bond performance relative to Treasuries.
Credit Fundamentals
While the economy returned to growth in the second half of 2009, high unemployment, weak consumer spending and lower property values all combined to take a bite out of municipal tax revenues, contributing to the well-publicized budget shortfalls in California and New York.
But Gotelli puts these issues in perspective: “While fundamentals are challenging for a number of municipal entities, we do not expect defaults at the state level, or widespread defaults among traditional municipal issuers, especially compared with the rate of corporate defaults. States are sovereign entities that cannot simply disappear, as corporations sometimes do. And they have enormous taxing powers and privileges that can be tapped further.”
Another key consideration is that continued improvement in the economy would be a positive for credit-sensitive municipal bonds. “Better growth goes hand in hand with higher interest rates—conditions that favor municipals over Treasuries,” offers Gotelli.
Risk in Perspective
Gotelli urges advisors and their clients to focus on the more realistic concerns of so-called “headline risk” and the possibility of credit-rating downgrades to some municipal issuers. Headline risk is the chance that political or financial news will cause investors to sell municipal bonds, pushing down prices. Despite reassurances such as ours and those of other reputable institutional municipal investors, retail investors still perceive default risk to be elevated, and that perception could get worse, especially if rating downgrades occur.
In this environment, Gotelli currently favors bonds from less economically sensitive sectors, such as higher education, water/sewer and electric utilities that offer essential services and impressive credit pedigrees.
Credit Research, Steady Hand Required
Heightened risks place a premium on security selection and careful credit analysis. Addressing these issues typically requires experience, analytical tools and insights that either are not readily available to advisors and their clients, or require more time than most individual investors can spare.
That’s why Gotelli suggests professional management with a strong track record of overseeing municipal portfolios through past economic and market cycles for investors’ core municipal bond holdings. In addition to the requisite credit and sector analysis, professional managers are better able to add value through duration and yield curve management.
Certainly, the central investing lesson of recent years is that the best response to rapidly changing economic and market conditions is not a knee-jerk reaction to the latest headlines, but a measured, balanced approach to managing prevailing risks and rewards. With that in mind, we encourage advisors to work with their clients to review investment goals and portfolio composition. Despite some well-publicized budget difficulties, the relatively high-quality, tax-free income that is a fundamental attraction of municipal investing remains unchanged.
IRS Circular 230 Disclosure: American Century Companies and its affiliates do not provide tax advice. Accordingly, an discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies of any of the matters addressed herein for the purpose of avoiding U.S. tax-related penalties.
American Century Investments offers a Short Duration bond fund for advisors and their clients. Its prospectus, which contains the fund’s investment objectives, risks, charges, expenses, and other information, can be obtained by calling 800-345-6488 or by visiting americancentury.com/ipro. Please read the prospectus carefully before investing.
The opinions expressed are those of the investment manager and are no guarantee of the future performance of any American Century portfolio. Statements regarding specific holdings represent personal views and compensation has not been received in connection with such views. This information is not intended to serve as investment advice.
P.O. Box 419385
Kansas City, MO 64141-6385
1-800-345-6488
www.americancentury.com/ipro
American Century Investment Services, Inc., Distributor
FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE
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