Thu, 27 Feb 2014
As investors realize the impact of new tax increases, municipals are going to become more valuable--but research is key to finding value and avoiding trouble, says Fidelity's Kevin Ramundo.
Jason Stipp: I'm Jason Stipp for Morningstar. It's Tax Relief Week on Morningstar.com. And of course, municipal bonds are an important tool in investors' toolkits when they're looking for tax efficiency. Joining us today to give us a sense of the muni market today and where they may be seeing opportunities is Kevin Ramundo. He is a comanager on Fidelity Tax-Free Bond. That's a Gold-rated fund by Morningstar analysts.
Kevin, thanks for calling in today.
Kevin Ramundo: Thank you, for having me.
Stipp: Kevin, income investors, particularly those in higher income brackets, will take a look at the tax equivalent yields on munis to get a sense of their attractiveness. As you're looking across the muni universe broadly speaking, are the aftertax yields enticing for investors right now given the risks that they would be taking on in the muni market?
Ramundo: Yes. I think we believe aftertax yields are enticing for the investors today. Investors are realizing this, as they fill out their tax forms. In 2013 you had the implementation of a new 3.8% Medicare tax on unearned income. You have higher marginal income rates, and you also have higher dividend capital gains rates. All of these factors have made municipals much more attractive for investors in the highest tax brackets.
We believe at Fidelity that as investors realize the impact of these new tax increases, municipals are going to become more valuable. There are other reasons to own munis. They service a diversifier within the context of a larger portfolio, and they are relatively a safe haven compared to other fixed-income sectors.
Stipp: When you're looking at how those yields have changed over time, have yields gotten better? If municipal securities have been under any pressure--there have been some pressure points in the headlines--what's the trend look like for what you are getting paid for the risk you are taking in munis?
Ramundo: I think generally speaking, yields have widened or gotten higher after the summer when the Fed made their announcement about tapering their bond purchases. So munis became that much more valuable. I think since then we have seen somewhat of a narrowing in that as the market has rallied somewhat in January.
Stipp: Are you using any areas of the muni market that look comparatively more attractive than other areas based on that risk/reward profile or the fundamentals?
Ramundo: Yes. There are. I think at Fidelity the key to finding value among investment-grade munis is doing really good research. There are thousands of muni issuers in our market, and a lot of them don't have notable name recognition or transparency to the retail investors that invest in muni bonds.
In fact, with retail investors, you can't buy AAA [rated bonds] from an issuer anymore. Here at Fidelity, we have a really robust research staff that understands and differentiates these credits. We have a really strong trading desk that pores through our market, and they look to identify value.
If you are going to pin me down, I'd say, one area that we are finding attractive is the health-care sector. Now this might surprise some because the health-care sector is experiencing operating pressures, and many health-care providers are facing regulatory constraints, demand constraints, and competitive constraints. But with uncertainty we believe there comes a great deal of opportunity. We have a very experienced group of health-care analysts, and we leverage them to take advantage of those opportunities.
Stipp: Kevin, you mentioned the Fed a little bit earlier and the impact that the Fed's tapering program has had on the fixed-income markets. Broadly it is expected that the Fed will continue that tapering program and that we will start to see rates normalize over a period of time. So as a manager of fixed-income portfolio or muni portfolio, how are you thinking about the impact that rising rates might have on the portfolio?
Ramundo: This is a question we do get a lot. And obviously rising rates present a challenge for bonds, and there are many factors that we take into account when we are making investment decisions in such an environment. I guess, first, I would say that if the Fed raises short-term rates that doesn't necessarily mean the prices of long-term munis are going to fall. Right now the muni yield curve is steep. And the credit spreads are still generous, particularly relative to historical norms. So there is still some room for long-term munis to improve.
Second, getting the timing right is really difficult. Now philosophically, here at Fidelity, we don't believe we should try to call the direction of interest rates. So if our shareholders want less interest-rate sensitivity they can buy one of our shorter-maturity products. So we don't second-guess shareholders by changing the interest-rate sensitivity of our funds.
Now with that said, there are a couple of things that we can do to mitigate the impact of rising rates. And we can do that without changing the overall interest-rate sensitivity of our funds. The biggest is probably yield-curve positioning. We tend to favor overweights on the shorter and the longer ends of a fund's maturity spectrum. So if the Fed raises short rates, long muni rates are not likely to rise as much. This type of portfolio structure should help our funds perform well against their benchmarks.
Finally, and an important point is, we are extremely focused on the liquidity of our funds, particularly given the shareholder redemptions the industry faced this past summer after they found the Fed announced its intentions to start with their bond purchases. So if rates start to rise we would expect further shareholder redemptions. The additional liquidity would allow us to accommodate some of the outflows that would ensue in such a market. I guess, overall when investors ask us about rising rates, we try to advocate a kind of a holistic approach toward asset allocation.
There are reasons why rates may remain low for a while, and investors should consider that as a possibility, as well. That means owning some bonds even when there is some interest-rate uncertainty. The same goes for investors deciding between short and long muni funds. Once again, it's really hard to time markets.
Stipp: Kevin, we talked about interest rates. I'd like to talk about credit quality. There've been a couple of high-profile cases--Puerto Rico and Detroit--that been in the headlines a lot and may have alarmed investors. When you are thinking about the credit quality of the muni universe, are these more like anomalies because we are also hearing about some municipalities starting to get better tax receipts and looking like they are in a little bit better health. So how do you think about the health of the muni market or is it really there is no health of the overall muni market? It's municipality by municipality, its credit issue by credit issue.
Ramundo: Let me break this down a little bit. I guess first, while I would not rule out the potential for future credit stress within the U.S. municipal market, I would say that Puerto Rico and Detroit for that matter is somewhat unique. Now let's stick with Puerto Rico first.
Puerto Rico is unique, particularly given the magnitude and breadth of their debt outstanding. They have close to $70 billion in debt and roughly 70% of U.S. mutual funds report holding Puerto Rico debt. So Puerto Rico certainly has some difficult challenges, particularly they contend with a whole host of issues. Their population is declining; their economy is struggling. They have significant unfunded pension and health-care liabilities. Their workforce participation is poor, and they have got very high social-welfare costs.
But despite some of these negatives, there have been pockets of encouraging news about the island's finances. But this prolonged economic decline has raised concerns from the market about their ability to meet their long-term obligations. That's Puerto Rico.
Now in contrast the credit environment for U.S. states has improved over the past year. Employment growth and market-driven gains have had a positive impact on tax revenues, especially those derived from personal income. So what we see is, we see the states use revenue growth to restore certain programs that have been cut. They are financing increasing pension payments, and they are actually restoring funding to local governments, particularly as it relates to education.
You also see states more prudently managing their long-term liabilities. So for U.S. states we are seeing improvement. The general trend for local governments is also one of improvement. Local governments have benefited from a recovering housing market. That's supporting healthier growth in property tax revenues, and that's also supporting a broader economic expansion. So for both U.S. states and local governments, we are seeing improvement.
Stipp: One more question on the Detroit situation. You mentioned these are localized situations. But the way that Detroit is advancing through bankruptcy, and some of the decisions that are being made in the courts as that happened, could conceivably have an impact on how other municipalities that are stressed now or maybe stressed in the future handle bankruptcy. To what extent are you looking at this Detroit situation, the process in the courts, and the possible impacts that it could have in the muni market later on?
Ramundo: We are looking at it very closely. And unlike Puerto Rico, Detroit can and has decided to pursue Chapter 9 municipal bankruptcy as a path toward recovery, so that's one distinct difference. Unfortunately, there is very little precedent surrounding Chapter 9. And of course, what this does is, this presents greater uncertainty for investors. As you can imagine, our market is extremely hungry for any precedent that will allow investors to better understand how the different classes of creditors within Detroit's bankruptcy will be treated.
Since we are in the midst of this bankruptcy, for us it's really hard to come to any firm conclusions. I guess one critical point is the stance that the Detroit emergency manager has taken with respect to the general-obligation debt. The emergency manager has categorized general-obligation debt of Detroit with all other unsecured creditors and has proposed a pretty significant haircut. And according to the most recently filed plan of adjustment, we are looking at an 80% haircut for all unsecured creditors, particularly for the general-obligation holders.
And historically muni investors may have thought that general-obligation bonds are viewed as a much safer investment. The ultimate treatment of Detroit's general-obligation debt in this bankruptcy case, we are watching it closely and the market is watching intently. Unfortunately, I think it's too early to offer any firm conclusions as to what that final outcome may be.
Stipp: Kevin Ramundo for Fidelity Tax-Free Bond, a Gold-rated fund by Morningstar analysts, thanks so much for calling in today and for your insights on the municipal market.
Ramundo: Thank you, my pleasure.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.