Wed, 16 Nov 2011
The muni market still faces challenges, but with careful research and disciplined risk control, muni investors have plenty of opportunity, says Fidelity's Mark Sommer.
Jason Stipp: I'm Jason Stipp for Morningstar.
Municipal bonds have long been a standby of fixed-income investors, especially those in higher tax brackets. But investors have been on a higher alert over the muni market over the last year.
Here with me to dig into some of the risks and the opportunities in the muni market is Mark Sommer. He's on Fidelity's muni bond team. [Fidelity Municipal Income] is one of Morningstar's Gold rated [funds] for municipal bonds.
Thanks for calling in, Mark.
Mark Sommer: Thanks for having me, Jason.
Stipp: The first question that I have for you: We've seen headlines over the last year about problems in municipalities, and more recently we saw the case in Jefferson County and also the case in Harrisburg.
I'm wondering about these cases and the impact that they might have on the market. We know that headlines don't tell the whole story. But when you look at these cases and you look at the overall health of munis, are these particular cases emblematic of a deterioration that you're seeing?
Sommer: Well, I think that those are fairly special cases and have been going on for quite some time now. They both have very unique circumstances.
More broadly, I would say that municipalities have been under pressure, more as a function of what the economy has been doing. So far, I think that, again broadly speaking, many cities and towns have been well positioned to weather the storm, but there have been pockets of difficulty. And we've certainly seen headlines around those, and we're not out of the woods yet, clearly. We could still see some pain in terms of reduced property taxes, which tend to fit with the lag. But we wouldn't expect to see what some have forecasted as being wholesale muni defaults anytime soon.
Stipp: So, I want to talk to you in a moment about some of the ways that you manage risk in the portfolio. But before we get to that, I'd just like to talk broadly about the sorts of yields we're seeing.
So, one of the things we talk about at Morningstar is the tax-equivalent yield. So, you want to look at the yields that you're getting on munis after taxes versus what you might be seeing in taxable bonds.
Our director of fixed-income research Eric Jacobson said in an interview recently that when you look at the yields that you're getting on taxable bonds right now, even folks who aren't in those highest tax brackets might benefit from looking at what their tax-equivalent yields might be in munis.
When you're looking at the marketplace, what kind of spreads are you seeing and what's the attractiveness of munis in that tax-equivalent context?
Sommer: Well, I think relative to historic norms, munis are at a very attractive point. Historically, people have looked at simple ratios of AAA munis to Treasury yields, and when those ratios have been over a 100%, they've deemed the municipal market as being extremely attractive on an aftertax basis. And some of those relationships have broken down a little bit because of the specialness of Treasuries and also because of the lack of AAA munis. ... And so those ratios are now well above 100% almost across the curve.
I'd say that the number of opportunities in the municipal market among high-grade credits is at a historic point at this moment in time. If there are silver linings coming out of the disappearance of the AAA monoline insurers and the other struggles that we've seen with the economy in recent years, it's that this is a market where spreads are at very attractive levels, and you don't have the insurers to hide behind.
So, for a lot of the credits in our market, where they're not as recognizable names and not all muni investors--especially retail investors who are buying munis on their own and who don't have the research resources to understand those credits--it's an incredible time for those of us who do have the resources and the experience to buy relatively high-quality credits at, I don't want to say unprecedented spread levels, because three years ago we saw even more attractive yield levels, but it's settled in to a point where you can still buy single-A credits of names that not everyone's familiar with at very attractive levels.
Stipp: So Mark, you started to talk a little bit there about the research capabilities. One of the things that our analysts have noted about your fund is that it's played defense well, that your risk controls have been strong.
So, ... in the context of the fact that some municipalities have had issues ... can you talk a little bit about the risk controls that you have generally, and then also specifically, if you could, ... how that's played out recently in some areas that maybe you have avoided in order to steer clear of potential trouble spots?
Sommer: I think, as soon as you talk about risk controls, what immediately comes to mind for most people are sophisticated systems, and in fact we do have sophisticated systems as well, but I would say the most important element of playing good defense is being disciplined, and that comes in a variety of ways. It speaks to how we manage the interest rate sensitivity in our funds, which is relative to the benchmarks, and it keeps us from changing the duration or interest rate sensitivity of the funds as we expect rates to rise or fall. It also impacts our sector investing to the extent that we can't get enough exposure on particular credits or more broadly within a sector such as the housing sector.
We've historically had lower weightings in tobacco, which is a highly technically driven sector. As high-yield funds are trying to get invested, you see valuations on tobacco very, very strong, and that's independent of the underlying fundamentals, or as you see specific legal rulings impact that credit, it becomes this very volatile and very technically driven sector.
And so I think what we subscribe to is understand what our core competencies are, and which sectors we feel we have a competitive advantage in, and one of those is health care. And also be incredibly patient, and this became very important in 2006, for example, when spreads were incredibly tight, and all investors were reaching for yield, and we were actually lowering our exposure to some of the higher beta credits in our market.
So it really has an across-the-board impact on how we think about investing, and I'd say last but absolutely not least, is to understand what investor expectations are. Muni investors are investing in these funds, we think, for relative safety, relatively low volatility, and that dictates the size of weightings that we have in sectors and the types of names that we buy.
Stipp: I'm glad that you brought up investors there, because the last thing I want to talk to you about is the investor behavior. You mentioned the importance of patience, and I think that's important across a lot of different asset classes in order for theses to play out on particular investments. But we know that fund flows, the money that people have put to work in municipal bonds versus the money that they have taken out of municipal bonds, have been going against the investments. So investors have been, based on our data, pulling money out except recently maybe they have been putting a little bit back to work.
So I have two questions for you here. The first one is, how have you been dealing with the fact that investors have tended to be somewhat skittish over some of the headlines that they've read about municipalities?
And secondly, do you think that there is any merit to that skittishness or have investors maybe let their emotions run away with them a little bit here?
Sommer: Well, we've seen fairly volatile investor flows over the last several years. This all started back in 2008 as the decline of the monoline insurers became apparent, and ratings on municipal bonds were in rapid decline, at least those of insured credits. And that resulted in the first significant wave of investor outflows back in the fall of 2008. This was post-Lehman bankruptcy. And at that point, it became clear, I think, across the entire industry, how critical it was to maintain the liquidity that you needed to be able to respond to those type of extreme investor flows, and at the time there were significant outflows, and we've seen periods of outflows most recently at the beginning of this year in the wake of the comments of some predicting hundreds of billions of defaults in our market.
I think there has been somewhat of an overreaction by investors at times, because our market has been relatively resilient over long historic periods, and there are good reasons for that. That's not to say that there aren't credits or isolated instances where municipal credits have, as we talked about earlier, either defaulted or the valuations have been impacted significantly, and that you need to do a lot of credit work in this market.
So I don't want to downplay or dismiss some of the challenges that our market has faced and will continue to face over the coming year. But I think it has also underscored how important it is in these funds to maintain adequate liquidity, both in terms of the overall credit quality of the bonds that you own, and also have the trading bandwidth and systems to be able to source pockets of liquidity even where the market is more broadly having trouble with significant shareholder volumes.
I think this is another place where our benchmarking philosophy or using benchmarks as a analytic tool--I should say, our benchmarks are not there to be replicated, but they are there as a tool for us to use as a guide in understanding the positioning of our funds ... The simplistic thing to happen would be that when there are significant shareholder outflows to sell the shortest bonds, for example, that a fund owns, but that would just increase the interest rate sensitivity of the overall portfolio. You might sell the highest-quality bonds and therefore allow the overall credit quality of the portfolio to deteriorate, but if you're using benchmarks as a guide, it enforces a discipline on you. As you source that liquidity, you are also keeping an eye on maintaining the overall portfolio characteristics.
Stipp: Mark Sommer of Fidelity's muni bond team. Thanks so much for calling in today and letting us pick your brain on the municipal market.
Sommer: It was my pleasure.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.