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Gauging Those Tremors in Municipal Bonds

Posted on Wednesday, January 12, 2011

MARILYN COHEN, the founder of Envision Capital Management, manages $300 million in bond portfolios for individual investors. Since early November, she says, she has also taken on the job of running “the municipal bond equivalent of the Butterball turkey hot line,” fielding calls from investors worried how to handle the sharp fourth quarter sell-off in municipal bonds.
From Nov. 5 to Nov. 17, the Barclays Capital municipal bond index fell 3.4 percent. A subsequent two-week rally recaptured about a third of that loss, but a second leg down, from Dec. 6 to Dec. 15, shaved an additional 2.5 percent from the index. All told, that benchmark muni index lost 4 percent in the fourth quarter, nearly a year’s worth of income yield for an intermediate-term, high-grade tax-exempt bond fund.
Ms. Cohen says municipal bond investors should buckle in for more volatility in 2011. “Long-term we have a lot to worry about,” she says, referring to the growing concern over whether some states and municipalities, short on cash, will be able to make timely interest payments on their bonds.
Municipal bond experts agree that there will be a rising number of muni bond defaults in coming years, but most say they expect that the scope and impact will be limited.
“The prognosis for an avalanche of defaults is way over the top,” says Hugh McGuirk, who oversees municipal bond funds at T. Rowe Price.
Jamie Pagliocco, lead manager of the Fidelity Municipal Income fund and director of Fidelity’s muni bond portfolio managers, concurs. “We don’t expect a wave of defaults,” he says.
In fact, Pamela Tynan, manager of the Vanguard Short-Term Tax-Exempt fund, says the cause of the recent sell-off in the municipal bond market has been “a near perfect storm” of events that “had nothing to do with credit issues.”
The European sovereign debt crisis reared up again in the early fall, as Ireland’s fiscal woes came to a head. That set off a new round of hand-wringing concern that states with extreme budget shortfalls — like California, Illinois and New Jersey — might be atop a list of the next “sovereigns” that won’t be able to keep up with debt payments. But bond managers say the comparison is faulty, and attribute the recent volatility to other factors.
For starters, Treasury rates began to creep up in the fall, taking municipal bond yields along for the ride. Mr. McGuirk notes that the interest rate on AAA-rated 30-year municipal debt rose to 4.9 percent in December from 3.7 percent in September. In the world of bonds, when yields rise, prices drop.
Then came the tax-bill compromise engineered by President Obama, which is conspicuous for two exclusions that are expected to affect municipal bond supply and demand next year and beyond.
On the supply side, the Build America Bonds program was not extended past its Dec. 31, 2010, expiration. Under the program, which was part of the February 2009 economic stimulus bill, the federal government agreed to pay 35 percent of the interest cost on taxable bonds issued by states and cities. The program shifted a sizable portion of new municipal debt — an estimated $185 billion — into the taxable market from early 2009 to the end of 2010. Issuers will now have to return to the traditional tax-exempt market to raise capital, increasing municipal bond supply.
The tax bill also left individual income tax rates unchanged for all Americans through 2012. That was a minor blow to the municipal market, which was anticipating an increase in demand if the marginal tax brackets for higher-income households had been allowed to rise in 2011.
THOSE pressures, combined with the specter of rising interest rates, are expected to add to volatility in 2011. And no one is dismissing the disruption that may come if some municipal bond issuers default on their payments.
“The number of defaults is likely to increase,” says Rob Williams, director of income planning for the Schwab Center for Financial Research. But he says he is not anticipating a systemic Armageddon. “The default rate won’t be zero,” Mr. Williams says, “but it isn’t going to be significantly higher than what we’ve seen historically.”
According to Moody’s Investors Service, 54 of 18,400 rated municipal bonds defaulted from 1970 to the end of 2009, or a minuscule 0.3 percent. Meredith Whitney, the market analyst who has recently focused her firm’s attention on the municipal market, recently said on “60 Minutes” that she believes we could see twice as many defaults in just the next few years.
Mr. Pagliocco at Fidelity says he’s not trying to “sugar coat” the seriousness of the deficit issues confronting state and local governments, but he says he does not expect inordinate trouble. He also says it is helpful to put the magnitude of state and municipality fiscal stress in context.
As an example, Mr. Pagliocco says California’s current debt as a percent of its gross state product — “what bond geeks pay attention to,” he adds — is about 5 percent.
“You can’t compare that with the 70 percent ratio for our federal debt-to-G.D.P. or the 100 percent or higher ratio for some European sovereigns,” he says.
A November municipal bond report from Fitch Ratings, titled “More Sparks Than Fire,” builds on that point by noting that because the cost of paying debt is a relatively small part of a state’s or a municipality’s budget, defaulting on that payment doesn’t do much to solve the bigger deficit issues.
Ms. Tynan at Vanguard adds that default is “an option of last resort that is arduous, and any entity that wants ongoing access to capital markets is not going to want to take this step.”
Amy R. Laskey, a municipal bond analyst at Fitch Ratings, points out that even if the municipal bond default rate were to triple — and she says she isn’t making any such prediction — it would still be below 1 percent. Because most defaults historically have occurred in unrated securities of one-time issuers — mostly in the housing and health care sectors — one way to protect a portfolio is to focus on investment-grade bonds of well-established issuers.
Harold Evensky, a financial adviser in Coral Gables, Fla., uses diversified mutual funds for his clients.
“That diversification and the fact that there is a bench of analysts doing the credit work is especially important right now,” Mr. Evensky says.
He acknowledges that if disturbing headlines cause investors to hit the “sell” button, funds could face a wave of redemptions that would require them to sell bonds in a falling market.
Mr. Evensky says his strategy is to stick with mutual fund companies “that don’t attract hot money and don’t have exciting managers.” He uses Vanguard funds for its short-term bond holdings, Thornburg funds for intermediate-term issues and T. Rowe Price for long-term municipal bond holdings.
Mr. Evensky has also reduced his exposure to losses from rising interest rates by lowering his target duration for client bond portfolios to about 3.5 years, from about 4.5 years in 2008.
MS. COHEN says she currently prefers owning individual issues rather than shares of mutual funds. In a rising rate environment, she likes the fixed maturity date of individual bonds, and wants to avoid the possibility of being caught in the wave of mutual fund redemptions if sentiment turns more bearish. She is also focused on high-quality, shorter-term bonds.
And she advises that, for now at least, investors play down the standard advice that general obligation issues — backed by the taxing authority of the issuer — are the safe sweet spot for conservative muni bonds. General revenue bonds may now be the safer place, considering that municipalities’ tax receipts — used to pay back general obligation bonds — _ are still recovering from the recession. And the once-sacrosanct pledge to raise taxes, if ever necessary, to fulfill the payback seems a bit shakier in today’s fiscal environment.
Revenue bonds tied to essential public services — like water and sewer operations — may be among the most solid because payments for these services, which in turn are used to make the bond’s interest payments, endure no matter the economic climate.
“I would rather own an essential revenue bond of the Los Angeles Department of Water and Power than a Los Angeles city general obligation bond,” Ms. Cohen says.

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