Thu, 27 Feb 2014
Morningstar's Eric Jacobson breaks down the nuances of GO, revenue, and tobacco bonds, warns about a yield pitfall to avoid, and offers best practices for researching muni fund portfolios.
Christine Benz: I'm Christine Benz for Morningstar.com.
It's Tax Relief Week on Morningstar.com, and municipal bonds are an important part of many investors' taxable portfolios.
Joining me to share some tips for assessing what's in your muni fund is Eric Jacobson. He's is a senior fund analyst with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Christine, great to be with you.
Benz: Eric, one of the big divisions in municipal bond land is between what's called general obligation bonds and revenue bonds. Let's talk about those two different categories and how investors should look at them.
Jacobson: As you say, these are two very big catch-all categories. I say that because there are certainly nuances underneath in terms of structures and guarantees that certainly are a little different from bond-to-bond and type-to-type underneath those big umbrellas.
But the general idea is that general obligation bonds are essentially backed by the full faith and credit of the issuer--very often a state, for example, or it could be another municipality. Effectively what they're saying is, it doesn't really matter where we get the revenues from, what kind of taxes, we're going to put you first and promise to back your debt with our full faith and credit.
Whereas, a revenue bond is set up specifically to channel the fees and revenues of a specific project, or a facility perhaps, that will fund the principal and interest of those bonds in such a way that even if the municipality that is associated with it runs into its own financial difficulties, you as the lender have the advantage of knowing that as long as the revenue-generating entity that's backing those bonds is in good stead and operating properly--especially if it's something really essential like a water treatment facility or something else where you know that it's going to be the last thing to ever get cut--then you know you can rely on that a little bit better.
Historically, I think a lot of people have favored general obligations over revenues, but that's changing a little bit because of things going on.
Benz: I wanted to ask you about that, because I think a lot of people do assume that those general obligation bonds are safer than other types of municipal bonds. Is that always the case?
Jacobson: I want to caveat that there are some nuances; a lot of it has to do with the way that the bond documents are written, the structures, and where the guarantees come from, and so forth.
But in general, it has historically been thought that GOs were really, really safe, because usually the taxing authority that has issued the bonds has a lot of ability, for example, to raise taxes, and in the minds of investors, to raise them high enough to be able to take care of that debt.
The complications that we've had over the last few years, certainly with the Detroit situation and some other smaller situations, take us to a little bit of new territory. There had been different kinds of concerns. Sometimes it's an issue of willingness to pay. Other times it's an issue of worrying that, perhaps, a court will override the structure and the promise in such a way as to give other creditors advantages that are either equal to or above those held by the GO bond owner in a way that was never supposed to happen.
It's the kind of a thing that a dedicated municipal analyst might want to think about. But at this point, it doesn't appear that it's really taking over the market, because it's such a small number of affected issues at this point. But it's certainly something that's made people nervous.
Benz: Morningstar.com provides some sector data for municipal bond funds, and people may also find it when they look on their fund company's website.
What are we to make of that information? Are there any rules of thumb you can give us when we're looking at that sector exposure? Which municipal market sectors are considered safer, and which are a little more risky in your mind?
Jacobson: A lot of it depends on the state, or the issuer, in terms of the GO question. There are absolutely some states where the finances are so strong, the economy is perhaps in better shape than other parts of the country, that [investors can say] this GO is really a solid choice, and we believe in the sanctity of that pledge. So, I don't want to discount that too much.
However, it's certainly been fashionable in recent years for managers to favor certain kinds of revenue bonds that are, as I alluded to before, backed by truly essential services--often water and sewer, different kinds of public-good essentials that roll up to keeping the lights on, and things that are going to be the last thing that any municipality or manager of any of those assets tries to cut back on.
Benz: One thing that you sometime see in municipal bond funds are what are called tobacco-related bonds. What does that mean? Why do those bonds find their way into muni portfolios?
Jacobson: That's a very, very interesting sector. As you may know, a handful of years ago the state attorneys general around the country entered into a settlement with the tobacco industry, known as the Master Settlement Agreement.
In effect, that structure promised essentially that the tobacco industry would be remitting settlement money back to the states over a long period of time. There are very complicated formulas to determine how much it is and there are issues of market share and other things. But the bottom line is, it's a very strong pledge that supersedes a lot of other things. It would be very, very hard for the tobacco industries to get out of it.
So many states have said, we've got these tobacco revenues promised to us and coming in. We're going to issue bonds against those revenues. So essentially, they borrow money upfront from the bond market and at that point promise that in order to pay the bonds back in the future, we will use these tobacco revenue streams. At the same time, we'll get to use this borrowed money upfront.
Benz: How prevalent are those tobacco-related bonds?
Jacobson: They're reasonably prevalent in the sense that they probably make up a few percentage points of the broader municipal market. Run-of-the-mill, broadly diversified municipal funds may hold a couple of percentage points [of these types of bonds].
You want to definitely take a look in your fund and see if it owns them, because there are handfuls of funds that use them much more generously, and the upshot of that is, there are big swaths of the tobacco market that, for a variety of reasons having to do with headline risk and other things, can be very, very volatile.
Benz: You have been talking a lot about how to do bottom-up analysis of municipal-bond funds, but I know that a lot of investors really shop for muni funds based on whichever fund has the best yield attached to it. What are the pitfalls of doing that and letting that be your key guide as to what to buy?
Jacobson: The tricky part of that concept is that the higher the yield on the fund, essentially almost for certain, the more risk it's taking and the more risk that you are therefore taking by holding it.
I don't want to overemphasize the point in the sense that, there are certainly going to be funds clustered in a range where some have higher yields than others, and it isn't necessarily a huge difference in risk. There are different reasons that can happen: Sometimes it's just expenses; sometimes it's accounting a little bit.
But effectively, if you find a fund that's yielding a whole lot more than the others in its group, it's almost certain that it is either taking on more credit risk, or a combination perhaps of credit risk and liquidity risk, because they own smaller bond deals that are not widely traded--and maybe your fund or fund company owns the whole deal.
It also could be a lot of extra interest rate risk built into the portfolio. You may not necessarily see it in terms of the stated duration number, but there are ways to ramp up income production through things like municipal inverse floaters, for example, that will result in a higher level of income, but also present potential extra volatility in terms of interest-rate sensitivity.
Benz: If I want to get beyond shopping on yield alone, can you give me a few pointers about how I might survey a municipal-bond fund, because I think a lot of investors crack open these portfolios with the best of intentions, but they are really not familiar with many of these holdings. They are not sure what they should be worried about or which bonds are actually pretty safe.
Jacobson: The first-pass recommendation that I suggest would be to take a look at the breakdown of a fund by credit-quality strata. In other words, how much of the fund is in AAA, AA, A, etc. While that may not intuitively mean anything off the top of your head, the first thing I would say is that the dividing line between BBB and BB, BBB being higher, is the dividing line between investment-grade and junk or high yield. In the municipal universe, a lot of debt you'll see is just non-rated. So, the message there is not necessarily that it's terrible to see any allocation below the line, but to understand that the larger that allocation, the more risk you are talking. Effectively, as you go down that stack of letters as I just described--AAA at the highest, than AA, A, BBB--the deeper you go into that stack of higher exposures, the more credit risk that your fund is taking on.
So, the most important thing to understand is really just what it means in terms of comparing funds to one another. There may be a very good fund that takes on more A and BBB risk, but you also want to know that if you are going to look at how it performs relative to a group of other funds, you've got to discount the fact that structurally it is just taking on more risk.
The next step that you probably want to take is to take a look at those percentages relative to the category averages for your fund, and that's one thing that you can do on Morningstar.com. Underneath the portfolio tab, when you are looking at any fund's data report, right around the middle of the page, we have a credit quality table. And beside the fund's bond percentages are the category averages.
Benz: So you can see how it fall in line with the category peers.
I assume that that other part of the style box, the interest rate sensitivity of the portfolio, is another key component.
Jacobson: Exactly. You want to take a look at the fund's duration, see whether or not that makes sense relative to the other funds in the group--how much higher or lower it is.
Also, I mentioned the inverse floaters earlier. It's a little bit arduous to do it, but you can dip into a fund's annual report or semi-annual report. You can scan it to see if it mentions inverse floaters. The bottom line is, if you look at the total assets and the total net assets at the end of the list of scheduled investments, if the total assets are significantly higher than the net assets, that indicates potentially some leverage being taken on, oftentimes through these inverse floaters, and that's a flag at least to try to understand better what's going on there.
Benz: Eric, thank you so much for being here to provide these pointers about how to do this due diligence on a municipal bond fund.
Jacobson: My pleasure, Christine. Glad to be with you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.