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An Interesting Muni Entry Point

Jeremy Glaser

Jeremy Glaser: For, I'm Jeremy Glaser. I'm very pleased today to be joined by John Miller. He is the Manager of the Nuveen High Yield Municipal Fund. We're going to talk a little bit about the municipal market and how the recent trials and tribulations there could impact investors?

John, thanks so much for taking the time today.

John Miller: Thank you for having me.

Glaser: So, a lot of investors who are in municipals think of them as kind of a staid asset class. Over the last few months there has been a little bit more volatility there than usual. Can you walk us through some of the key drivers of that recent volatility?

Miller: Absolutely, the municipal bond market has been hit by certain activities, some of which are technical in nature, so there has been a lot of new issue supply coming into the year end 2010. At the same time, municipal investors have pulled money out on net from open-end mutual funds and that's created at least temporarily a shortage of demand for some of those bonds. That has been heightened by credit fears, which in our opinion, are overblown on a broad-based basis. Even though there are some credit risks in the municipal bond market, we think that there are actually some improving trends here.

So, it's created an interesting entry point for some investors looking to get exposure to tax-free bonds because they yield significantly more than most bonds even in the taxable corporate bond market or in the treasury market. Again, I think some of these fears are perhaps exaggerated a little bit on the credit side.

Glaser: Let's take a look at some of these issues, the first being new issuance. How much of this was driven by the expiration of the Build America Bond program? How much do you expect to see increased issuance in the municipal space over 2011?

Miller: That's been a significant factor. A lot of this is political. The Build America Bond program was instituted by the American Reinvestment and Recovery Act, which started back in early '09 and it's been a nice tool for municipalities to access the capital markets issuing taxable bonds. Now, that program expired at the end of 2010, but issuers wanted to take advantage of that program. So, they took advantage as greatest extent possible by issuing as much supply as they could in the fourth quarter of 2010, bringing total 2010 supply up to $430 billion, which is a lot for the municipal bond market.

I see supply trailing off. It's gotten off to a very slow start thus far in 2011 and we expect 2011 to be a relatively low supply year. Plus municipal bonds are constantly getting called and investors are receiving sinking fund payments, which are partial principal payments and bonds always maturing in the muni bond market. So, we could be going from an overabundance of supply in the fourth quarter of 2010 to much lighter even scarcity of supply in 2011.

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Glaser: Credit is an area that a lot of people are very focused on. There was a Times article recently that kind of floated this idea that states may be – given an option to seek bankruptcy. Do you think that this is a lot of protocol maneuvering or do you think there is a real threat of municipalities and states truly going bankrupt?

Miller: Some municipalities can go bankrupt at the local level. It remains very, very rare. I personally do not believe that a state can or will go bankrupt. I think there is some politics in Washington D.C. discussing the possibility really in the vein of how do municipalities get their costs, predominantly labor costs and pension obligations under control on a going forward basis. It's actually a positive thing to work on municipalities controlling their costs on a year-over-year basis going forward. I don't think bankruptcy is the right tool.

As of today, states cannot declare bankruptcy and only about half the states even authorized that as possibility for local governments or cities. So, it remains extremely rare. It's a very costly tool and I think that it will continue to remain rare in the future even while municipalities are looking for different ways to cut costs and as they do cut costs and raise more revenues, that's a positive for getting our municipal governments into better fiscal balance going forward.

Glaser: But it hasn't seemed like that cost cutting will come on the backs of current municipal bondholders?

Miller: No. we don't believe so. I mean, the actual facts of the matter are that if you look historically, not only have defaults remained at a small fraction of 1% for the overall $2.9 trillion municipal bond market historically, but also what defaults that have occurred, the grand total of $8 billion in 2008 falling to $7 billion in 2009 and falling sharply to $2.5 billion in 2010, so it's on a declining trend. That's what a lot of people maybe don't realize is that actual municipal defaults have been on a declining trend and we think with economic improvement, tax increases, more revenues coming in municipal coffers that declining trend in defaults will continue going forward.

Glaser: You mentioned that the downturn has created some opportunities for investors, certain areas of the muni market you think look more attractive than others?

Miller: Sure. There is a couple of reasons why I would say that it is an attractive entry point. First of all, a lot of the sell-off in my opinion is technical, so temporary supply and demand imbalances. Some of the sell-off is also heightened by fears of a string of municipal bankruptcies which we don't think will occur. So, as I mentioned, I think some of those fears are overblown. But what has resulted from this is that high quality municipals, AAA municipals and AA municipals yield more than U.S. treasuries even on an unadjusted basis, just the gross yield munis versus the gross yield of treasuries is higher and that's an unusual situation.

But in addition, munis trade with a credit spread. So yield premium over and above the AAA munis for As an extra roughly 2% and for BBB rated munis, which are actually investment quality, that's in the neighborhood of 2.75% on top of the 5% that municipalities yield on a AAA side. So BBB essential service revenue bonds are I think an attractive opportunity right now because that's a wider spread than the long-term historical averages.

Glaser: Now, on the flip side, do think there is any areas that investors may be shouldn't be as interested in right now?

Miller: Well, I think that every municipal credit has to be looked at on its own merits. I would be aware that municipal insurance, financial guarantee insurance is not a big factor in the marketplace. So what that means is that in this very, very diverse market investors have to look at credits one credit at a time and there are certain parts of the country there are certain sectors that are struggling; some nursing homes, some ethanol producers, special facilities bonds, private projects have struggled and do have more distinct credit risks. That is an area where a lot of research is necessary before putting capital to work.

Also just a quick statement about ratings agency ratings, some of them might be old and the municipal market has changed dramatically over the last several years. So you need kind of a refreshed view, fresh set of eyes on what's been happening with the credit most recently to be certain of what the characteristics are now.

Glaser: So jumping blind into the muni pool might not be the greatest choice?

Miller: No, again, it's very diverse. There are credit risks, there are liquidity concerns one has to be cognizant of and for all those reasons you would not want to go blindly into one issue and we also recommend investing in municipals in a diversified way.

Glaser: John, thanks so much for your insights today.

Miller: Thank you very much.

Glaser: For Morningstar, I am Jeremy Glaser.