Adding to Our Pro-Muni Arguments
American Century Investments
January 25, 2012
Picking up where he left off last month (Weekly Market Update, December 13, 2011, “The Credit Research Case for Using Muni Funds”), Senior Vice President and Senior Portfolio Manager Steven Permut continues to explain why the fixed income portfolio management team at American Century Investments favors municipal bonds (munis) in 2012. He suggests core, diversified muni mutual funds for establishing and maintaining professionally managed muni positions in broader, diversified, long-term investment portfolios.
Credit Risk Factors that Professional Management Can Address
Among the pressures and risks we discussed last time were the ongoing budgetary shortfalls and related hurdles still facing muni issuers. We think most of these issuers can cut costs and raise taxes when forced to, as they are now. But their challenges do open the possibility of more credit rating downgrades (we think there will be significantly more downgrades than actual defaults) and additional “headline risk” (negative headlines about specific isolated events that trigger broader market volatility).
These ongoing risk factors can create tracking and decision-making challenges for investors and advisors. This credit diligence is a reality of muni investing that we believe can be made considerably less daunting for investors and advisors by assigning it to the credit research and portfolio management teams at professionally managed muni mutual funds (which can be accomplished by buying shares of those funds instead of individual munis).
We also spotlighted the exit of the bond insurers, following the demise of their AAA ratings. This, too, makes it more difficult for individual investors and advisors to evaluate and track the credit quality of individual munis on their own.
We believe credit risk evaluation, credit risk management, and the ability to distinguish opportunities from landmines are compelling arguments for considering professionally managed muni fund investments instead of individual munis.
Evergreen Strategic Attributes
After reviewing these credit risk factors, it’s understandable that someone would ask, “Remind us again why you’re bullish on munis—we’ve heard enough about risks, now what are the potential rewards?”
Great question. Though the economic and market environment has been challenging over the past three years, munis continue to offer evergreen, fundamental strategic attributes that can appeal to investors and advisors in a variety of investment environments. As we outlined last time, these include:
- Competitive yields, particularly on an after-tax basis for tax-sensitive investors in high tax brackets.
- Generally high credit quality, relative to other bond sectors. Lower default risk has become increasingly important to investors and advisors following the U.S. subprime mortgage debt meltdown and Financial Crisis in 2007-08 and the European sovereign debt crisis more recently.
- Diversification and risk-adjusted return attributes. Investment-grade muni performance tends to be correlated with that of U.S. Treasuries (which serves as a useful diversifier from stock performance) but not 100% correlated. Munis’ reaction to changing economic conditions typically lags that of Treasuries, with less severity. This relative moderation can produce favorable risk-adjusted returns for munis compared with other bond sectors.
Completing Our Yield Comparison
We mentioned yields last time, but didn’t go into much detail. In this low-yield, uncertain economic environment, finding competitive yields in high-quality investments is a challenge for individual fixed income investors, advisors, and institutional investors alike.
Fortunately, munis continue to offer competitive yields, particularly on an after-tax basis for tax-sensitive investors in high tax brackets. For example, today’s top 35% federal income tax rate basically means that after-tax yields on many taxable bonds (and bond funds) may be effectively 35% lower than the stated yield for taxable investors in the highest federal tax bracket. Put another way, federal tax-free muni (and muni fund) yields can be adjusted upward 35% for after-tax comparisons with other sectors such as corporates (shown below) for taxable investors in the highest federal bracket.
Figure 1 illustrates this concept, and how it can favor munis.
Muni yields that are also state tax-free in high income tax states (such as California and New York) may be adjusted even higher for tax-equivalency comparisons. Furthermore, the possibility of even higher tax rates to balance federal, state, and local budgets could potentially enhance this yield benefit.
A Tactical Consideration: Relative Value
In addition to the evergreen strategic attributes outlined above, sometimes there are other potentially favorable factors that make munis even more compelling on a tactical basis.
For example, finding relative value among high-quality bonds in this post-rally bond market environment is a significant tactical challenge for investors and advisors. We believe munis can help answer that challenge in 2012.
Why? Because there are typically periods during economic and/or market cycles when munis can offer attractive relative values compared with other bond sectors, particularly U.S. Treasuries. This often occurs during and after significant Treasury rallies, such as what we saw in 2011, when Treasury prices rose significantly and yields fell. (In 2011, the 10-year U.S. Treasury note returned 17.18% as its yield declined from 3.30% to 1.88%.)
We can see the relative value relationship between munis and Treasuries graphically illustrated. One key relative-value metric—the ratios of AAA muni yields to U.S. Treasury yields of the same maturity—exceeded 100% for much of 2011 (vs. historic averages of closer to 95%), which could continue into 2012. The graph below illustrates muni/Treasury yield ratios over the 10 years ended December 31, 2011. Periods when munis were relatively cheap compared with Treasuries show clearly as spikes above the 100% line.
Based on the opportunities and attributes outlined in this and our previous article, we believe conditions can potentially favor muni investments in 2012 and beyond. We typically suggest using established core, diversified muni mutual funds with long performance records, instead of individual securities. Muni mutual funds can provide professional credit analysis as a key facet of their portfolio management expertise. We believe strongly that experienced, effective credit analysis and credit risk management are important value-adding components that can help give muni fund investing a leg up over investing in individual munis. The professional portfolio management that muni funds offer can also help unlock the yield and relative value opportunities we see in the market today.
Barclays Capital 10 Year Municipal Bond Index
A rules-based, market-value weighted index engineered for the long-term tax-exempt bond market. This index is the 10 year (8-12) component of the Municipal Bond Index.
Barclays Capital U.S. Corporate A-Rated Bond Index
Consists of publicly issued U.S. corporate and specified foreign debentures that are registered with the Securities and Exchange Commission and meet specific maturity, liquidity, and quality requirements. This index is the A-rated component of the U.S. Corporate Investment Grade Index.
The opinions expressed are those of Steven Permut and the fixed income portfolio management team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
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.
This information is for educational purposes only and is not intended as investment or tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any 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, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
Data presented reflect past performance. Past performance is no guarantee of future results. Current performance may be higher or lower than the performance shown.
Diversification does not assure a profit, nor does it protect against loss of principal.
(c) American Century Investments
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