Muni Outlook Q&A with Portfolio Manager Alan Kruss
American Century Investments
February 23, 2012
Municipal bonds (munis) are back in the bond market spotlight, but for different reasons than a year ago (when widespread defaults were projected, and muni funds experienced heavy outflows). Muni performance has rebounded strongly since then, which has triggered follow-up questions about the muni market outlook. We posed them to Alan Kruss, Vice President and Municipal Portfolio Manager at American Century Investments.
Munis had an excellent run in 2011, which has continued (year to date) into 2012. Given this performance, do you think that munis have become overpriced?
The simple answer is no. But there are nuances to that answer that we think all muni investors should consider.
We view muni value from several different perspectives, two of which are:
- long-term strategic value
- near-term tactical value
In terms of long-term strategic value, we believe that munis continue to offer fundamental attributes—with evergreen appeal to investors—that haven’t changed, despite the muni market volatility of the past three years.
Strategically, over the long-term, for investor portfolios, we believe munis still offer the potential for:
- Competitive yields, particularly on an after-tax basis for tax-sensitive investors in high tax brackets.
- Relatively high credit quality, compared with other bond sectors. We believe muni credit quality overall is second only to that of U.S. Treasuries in the investment-grade bond universe, despite pockets of weaker credit that merit careful monitoring.
- Favorable risk-adjusted returns. 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.
What about near-term tactical value?
From that perspective, there’s still value, but the recent rally makes the story less compelling than it was a year ago or in 2008-09, especially in the short-to-intermediate-term part of the muni maturity spectrum.
During economic and bond market cycles, we typically see periods when munis can offer attractive relative values compared with other bond sectors, particularly U.S. Treasuries.
One key relative value metric we track is the ratio of AAA muni yields to U.S. Treasury yields of the same maturity. Typically, tax-exempt muni yields are lower than taxable Treasury yields of the same maturity by a factor related to muni yields’ federal tax-exempt status (which, on an after-tax basis, effectively raises muni yields compared with Treasury yields). So the yield ratio of muni yields/Treasury yields is usually less than 100%.
But this ratio can become skewed if the relative value relationships between munis and Treasuries significantly change. 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, according to Barclays Capital, the 10-year U.S. Treasury note returned 17.18%, as its yield declined from 3.30% to 1.88%.) When Treasury yields fall significantly, the muni yield ratio typically rises.
That’s exactly what happened in 2011, plus muni yields were elevated for a time by default concerns. Yield ratios exceeded 100% for much of 2011 (vs. historic averages of closer to 95%), which has continued in 2012, primarily at the longer end of the muni yield curve. As a result, we believe the long end of the municipal yield curve offers the best relative value versus Treasuries. (See Figure 1 below.)
Last year, in our muni portfolios, as muni and Treasury yields diverged, we implemented a ratio trade in both the 10-year and 30-year spots on the curve, when ratios were 115-125%. Recently, as ratios compressed (see the far right side of Figure 1), we unwound the trade completely.
We expect to revisit this trade if ratios cheapen to around 100% in the 10-year part of the curve. In the meantime, we continue to believe in the long-term, strategic value of munis.
Where along the credit-quality spectrum are you finding the best values? Why?
Lower down in the quality spectrum is where we believe the best values reside. Why? One reason is that much of the demand for munis over the past year has been for the perceived highest-quality AAA munis, particularly from non-traditional muni investors who “crossed over” into the muni market. They saw relatively high yields and low values to pursue, but wanted to try to minimize their credit risk.
We believe the yield differences (spreads) between AAA and lower-rated munis remain relatively wide (see Figure 2 below). As a result, we are positioned with a slight “credit overweight” (overweight in securities rated BBB and below) in our core, investment-grade muni portfolios relative to their benchmarks.
Going forward, we believe that further credit-rating downgrades and negative headlines will continue to warrant credit caution (putting a high value on effective, experienced credit analysis), but we believe the market will reward superior security selection over time. Therefore, we continue to look for opportunities to selectively add bonds in the BBB, A, and AA ratings categories at appropriate spreads within sectors we believe offer the greatest expected returns, based on our macroeconomic outlook and supply and demand patterns.
It’s important to note that despite our “credit overweight,” the credit quality of our investment-grade portfolios remains well within the investment-grade spectrum.
Do you think that fear about the solvency of larger states like California and Illinois is overblown? Do state-level defaults pose a major threat to the muni market?
As we’ve said consistently over the past three years, we don’t believe any states will actually default, though their credit ratings are likely to remain under downward pressure. We believe that even cash-strapped states such as California and Illinois have too many financial resources available to them and revenue-generating/cost-reducing avenues to pursue to make default a likely outcome.
We believe last year’s projections of widespread defaults focused excessively on projected municipal liabilities and underestimated the issuers’ ability to raise taxes and cut expenses. It’s worth noting that over the last four years, states largely reduced their spending (see Figure 3 below) and have closed more than $500 billion in budget shortfalls.
Regarding the state of California, specifically (which is where our municipal credit research and analysis team is located, allowing us to monitor the situation closely), its economy and budget situation have improved over the past three years, but its finances, particularly its liquidity, remain strained. Revenue shortfalls, particularly from overly optimistic estimates of personal income tax revenues, are responsible for some of the deficit, as are debts that have been pushed forward from past years.
But it’s important to remember that California state general obligation (GO) debt service has a high-priority claim on the state’s general fund revenues, and the state uses various cash flow management procedures to ensure it has sufficient money to pay its debt, such as deferring less-essential spending and issuing IOUs.
We believe the key for California is the economic environment—if it continues to improve, as it did in the fourth quarter of 2011, rising tax revenues should help ease some of the fiscal pressures. We own California GOs in our muni portfolios, but we remain slightly underweight our benchmarks. This is not so much because of credit conditions (in fact, Standard & Poor’s raised its outlook on state of California debt to positive on February 14, 2012), but because the bonds have been trading at fairly tight yield spreads (relatively high values). We believe these tight spreads somewhat limit their appreciation potential.
Regarding the state of Illinois, specifically, Moody’s Investors Service recently lowered its rating on Illinois GO debt to A2 from A1, making Illinois the lowest-graded U.S. state (by Moody’s standards). Moody’s revised its outlook because the state “took no steps to implement lasting solutions to its severe pension underfunding or to its chronic bill payment delays.” But a downgrade does not mean imminent default—an A rating is still investment-grade.
Important note: We have considerably more relative exposure to California than to Illinois in our muni portfolios. For example, one of our core, diversified, investment-grade muni portfolios has an approximately 18% weighting in California munis, compared with 4% in Illinois. However, on a market-value basis, relative to its benchmark, we are underweight California munis by -2% and market neutral in Illinois munis.
We own both California and Illinois state GOs, but most of the munis we own that are issued in these two states are not state GOs. In the same portfolio mentioned above, on a market-value basis relative to our benchmark, we are underweight nearly -2.5% in California GOs and -0.06% in Illinois GOs, respectively.
Has the Fed’s disclosure that it may not tighten monetary policy until 2014 precipitated any changes in your muni portfolios?
Interest rate policy and the direction of interest rates are less important to us than other factors over which we can exert more control and forecast more reliably. That’s why we typically don't make large duration bets in our muni portfolios. (Duration is a measure of a bond portfolio’s price sensitivity to interest rate changes; longer durations, which are measured in years, typically mean more portfolio price sensitivity to rate changes. Therefore, longer-duration portfolios are typically more volatile—prone to price changes when interest rates move—than their shorter-duration counterparts.)
We typically manage our muni portfolio durations within a band of +/- 0.2 of a year relative to the durations of their benchmarks. For the reasons listed above, and because our Macro Strategy Team’s view is that the U.S. economy will remain fragile and basically "muddle along" for a while, our muni portfolio durations are positioned close to neutral.
This doesn't necessarily mean that we won't extend muni portfolio durations in the future. While our Macro Strategy Team sets the overall yield curve and duration targets for our fixed income portfolios, the individual sector teams, such as the Municipal Bond Team, are responsible for security and sector selection, which can also affect portfolio duration.
What’s your outlook for new supply (bond issuance) in the muni market in 2012?
That’s a good, relevant question, because reduced issuance definitely was a factor in the muni market’s strong performance in 2011.
Total tax-exempt municipal bond issuance was approximately $255 billion in 2011, or nearly 8% lower than 2010’s issuance of $275 billion. For 2012, we expect issuance to increase to approximately $275-300 billion, which is still well below pre-Great Recession levels (see Figure 4 below). So supply is still relatively low. Meanwhile, demand levels are strong.
How would you summarize your muni outlook?
We’re optimistic, especially from a long-term, strategic perspective.
We think it will be difficult, in 2012, to replicate last year’s strong returns, given that 2011 started at such a low point for the muni market and ended at a comparatively higher one. But we believe there’s still plenty of room for comparative outperformance for munis versus other bond sectors if economic conditions continue to improve and the Treasury market softens. There’s still value and appreciation opportunities in certain parts of the market, and we still believe in the sector’s three main longer-term strategic attributes—competitive yields, relatively high credit quality, and potentially favorable risk-adjusted returns.
For investors who desire muni exposure, we typically suggest using established core, diversified muni mutual funds with long performance records, rather than individual securities. Muni mutual funds can provide professional credit analysis as one of their services. We believe strongly that credit analysis and credit risk management are important value-adding components that can help give muni fund investing a mind-easing edge over investing in individual munis. Professional portfolio management can also help unlock the yield and relative value opportunities we see in the market today.
The opinions expressed are those of Alan Kruss 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.
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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.
Alan Kruss, Vice President and Portfolio Manager
Alan Kruss is a vice president and portfolio manager for American Century Investments, a premier
investment manager headquartered in Kansas City, Missouri. He works in the company’s Mountain
View, California office. Alan is part of the municipal bond team and manages American
Century Tax-Free Bond and California Tax-Free Bond. Alan has worked in the financial industry
since 1997, when he joined American Century. He holds a bachelor’s degree in finance from San
Francisco State University.
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