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By Miriam Sjoblom, CFA | 02-04-2011 02:05 PM

'Panic Market' in Muni Bonds

Franklin Templeton's Rafael Costas believes that exaggerated fears about muni defaults, along with a few technical factors, led to the recent sell-off in the sector.

Miriam Sjoblom: Hi, I am Miriam Sjoblom, associate director of mutual fund analysis at Morningstar. I am here today with Rafael Costas, who is the co-director of municipal bond department at Franklin Templeton. Thanks for joining us today.

Rafael Costas: My pleasure, and thanks for inviting us.

Sjoblom: Well, its great to have you here because there has been just a ton of headlines in a lot of the mainstream news outlets about the really scary state of municipal finances. Investors have been experiencing losses in their muni funds, and many have been taking their money out at very quick pace over the past couple of months. So, just to start out, I think it would be interesting to address some of the headlines that are getting people pretty nervous and hear your take on some of the reports that are out there.

Costas: Well, there has been quite a lot of press given to some of the stories and claims that people are making about the state of, like you say, the bad state of municipal finance. And they're now projecting on the worse case that there will be a state of defaults that will cause hundreds of billions of dollars in losses for investors in defaults. And that of course is going to get people's attention, and that kind of story has gotten a lot of press both on T.V. and in the print media and unfortunately in the kind of media that a lot of people watch, including our shareholders and municipal bondholders across the country.

So, it did not help what was already going on. There was a bit of a sell-off at the end of last year that was caused by some technical issues. But once that story broke it really accelerated people's concerns, and we have been dealing with essentially a panic market for the last few weeks. It has been subsiding finally, but a lot of the claims were exaggerated based on what we think are the facts and history.

If you look at the last year, there were some 70 defaults according to Bloomberg that added up to about $2.5 billion, and now that is a lot of money or at least sounds like a lot of money. The year before there were $8 billion in defaults, and that was our worst year. But you got to keep in mind that's out of a $3 trillion market, and so when you look at the percentage, now you're talking about less than one tenth of 1% last year, maybe a quarter of 1% the year before. This is in the throes of the greatest recession we have seen since the 1930s.

Now to project that into hundreds of billions of dollars, you're calling for an increase in default rates some 40 times, and that is just frankly not something that we expect to see. We think the recession is over. We're starting to see recovery already, and we're starting to see municipal revenues go up.

We're not out there saying that the worst is totally behind us. There is a lag in municipal finance for revenues. So, we do expect that there might be more downgrades again this year. We do expect to see some defaults go up again this year but nowhere near of what people are calling for.

In terms of municipal bankruptcy ,which is another issue that people bring up, last year we had six municipal bankruptcies. Municipalities file under Chapter 9 of the bankruptcy code and as you know, businesses through Chapter 11. There were six last year; there were 10 the year before, the worst year of the recession.

There have been some 600 and change municipal bankruptcies since 1937 and to put that again into perspective, while the numbers might sound scary, there were 14,000 Chapter 11 bankruptcies in the last year and 14,000 or so the year before. So, you're comparing 28,000 bankruptcies in Chapter 11 to 16 in municipal bankruptcies and calling that a crisis, and that's where I think a lot of investors are being underserved by a lot of these reports in which people are not doing all their homework to put out a more balanced story.

Now, lately we have seen more people with real municipal experiences telling that side of the story, and we hope that's contributing to the lower level of redemptions that we are seeing in the last few weeks. And I should add that the bulk of these defaults are bankruptcies, and one doesn't equal the other. Furthermore, the bankruptcies are where you would expect them to be--the high yield side of the market, which is 7% to 8% of municipal market.

So I don't want to see that tail wagging the whole dog and causing people to believe that entire municipal market is under siege. We are having issues, but we're working through them. I don't think that you should be expecting a lot of defaults like the way some of these stories are going on about.

Sjoblom: Some of the reports have talked about this year being a difficult one because the federal stimulus money that some state and local governments are relying on is gone. So what are you seeing? How are states and local governments going to get through this time?

Costas: It will be very difficult for them this year. As you said, there is no federal stimulus money to count on this year. The year before that, the first true year of recession in terms of the budget cycles, they had these rainy-day reserve funds that they have built in the good years, and they have blown through that already, too. So this year rather than a lot of accounting games and counting on money that is now what you call recurrent, they really are going to have to make some very difficult cuts that are not going to sit well with the population whether it be from the tax side or the expenditure side.

But the fact is as states and municipalities are required essentially by law to balance their budgets every year. So the numbers at the beginning of the year that the pundits like to throw around are very alarming. They're big; they're $25 billion in Californian deficits. The fact is that ugly as it might be, at the end of the cycle, there is a balanced budget, and it's going to be done by a combination of an increase in taxes--which you here in Illinois just are going to experience now, an increase in your personal income taxes--and also another mix of reducing some expenditures that people maybe got used to having for the last 20 good years.

Now, unfortunately there is not enough money. There is really no money to be paying all these expenses that we have been incurring. Bonds are essentially sacrosanct at the GO level. They need to be paid in Illinois and in California, it's an automatic. The state doesn't get to decide if it's going to pay the debt or not. It's a continuing appropriation. So they come--and California has a special case with schools--and they get some 35% to 40% of budget first, but after that it's bonds. You see that all across the states.

So there are people concerned about the safety of their GO debt. Again, we think that's not very well-founded on facts and the fact that debt is only 5% to 7% of your overall expenses. It's not what your problem is. But there will be a lot of headline risk, and even though the market seems to be feeling better now than it was just three to four weeks ago, there is still the risk as we move closer to this deadline of June 30 when most states and municipalities do have a balanced budget in place that there will be very difficult cuts to be made and a lot of politicking and posturing that might make people more nervous.

So the market remains a little fragile, and we expect that you might see some heightened volatility as we get toward our process, but that's different than saying that there is a lot more credit risk. That's a very different question.

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