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Managing Risk in Munis

Christine Benz

Christine Benz: Hi, I'm Christine Benz from Morningstar.com.

It's Tax Relief Week on Morningstar.com. Here to discuss what's been going on in the municipal bond market is Miriam Sjoblom. She is associate director of fund research at Morningstar.

Miriam, thanks so much for being here.

Miriam Sjoblom: Good to be with you, Christine.

Benz: So Miriam, there has been this very public debate brewing about how worried people should be about what's going in the municipal bond market. Could you discuss both sides of the debate; the very worried camp, as well as people who are saying, "Ah, it's probably not such a big crisis"?

Sjoblom: Well, you know, the most famous declaration was Meredith Whitney's appearance on 60 Minutes, where she predicted there would be 50 to 100 sizable municipal defaults amounting to hundreds of billions of dollars.

Since then you had a number of commentators come out and say, "perhaps we think that's a bit exaggerated," but there are some concerns. I think what the concerns boil down to is that, since 2008 state and local governments have been facing very large deficits that they've been struggling to close.

So, the way they've done that is a variety of ways. A number have had rainy day reserve funds that they built up during the good times. They've had help from the federal government through the American Recovery and Reinvestment Act of 2009. Some of them have used one-time accounting gimmicks to plug holes in their budgets, and then, many have just been raising revenue through tax increases or fee increases and cutting services and that type of things.

So, the concern is, states and local governments are still facing these huge budget deficits, but some of these fixes are not there anymore. The rainy day reserve funds are depleted. The federal aid is drying up this year. So, you have some really hard political decisions that these governments need to make. Cutting services that their constituents really like and some depend on, as well as raising taxes and revenues. So, it's a really difficult environment, and it's definitely a challenging one.

Benz: So, Miriam, how about in the, "don't panic" camp? Are there people who are more sanguine, and why is that?

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Sjoblom: Well, I think that the old justification that muni defaults will stay low just because they always have been is really out the window these days. But if you take a more forward-looking perspective, some analysts are bringing up some very good points and that is, comparisons are made to the Eurozone sovereign debt crisis--compared to countries like Greece and Ireland, debt size, debt loads are pretty manageable for municipalities, and interest costs are actually quite manageable as well and not outside of the historical norms for municipal issuers.

Another factor to take into account is that, munis tend to issue in sort of even chunks over very long periods of time. So, there doesn't tend to be a big amount that's maturing in the near term, which is a problem for some of these sovereign states. So, if you're issuing debt over 30 or so years, it's all pretty evenly distributed. There is no debt rollover issue to really be concerned about.

Another thing is local governments is an area where people admit, this looks like a vulnerable area because states provide a lot of aid to some local governments, a lot of funding. So, if states are cutting their own budgets, then local governments could be at risk.

But I think it's important to note that, if you exclude high-yield issuers, local government debt makes up about 13% of the market; about half of the market is still very high-quality, essential service revenue bonds, important non-profit institutions like a Harvard. These are insulated from these kind of budgets, state and local government budget issues. So, there is still a good portion of the market that should hold up pretty well.

Benz: Okay. So Miriam, one thing we saw especially in the last quarter of 2010 were these big redemptions in municipal bond funds, investors pulling their money out, and that in turn, do you think put some pressure on the market? What have you seen so far this year? Has that trend reversed itself somewhat?

Sjoblom: It hasn't reversed itself. Outflows have definitely slowed, though. We saw around $13.5 billion in net outflows in December, $12.5 billion in January--very large numbers. In February, we saw estimated a little over $4 billion in outflows. So, still not a lot of appetite out there among retail investors.

Benz: You had mentioned to me that actually because retail investors are such a big share of the muni bond marketplace, that that's enough to put some pressure on bond prices, right?

Sjoblom: It is. You've actually seen some recovery in February and more recently in the markets, what looks like some stability in the pricing. Actually, that has coincided with a very low level of issuance relative to what we'd seen historically, and part of that is because issuers have some flexibility around when they can issue bonds.

So, I think the memories of November and December are still in issuers' minds--they don't want to press their luck. In a lot of cases, they're not issuing because they can't issue bonds, but they are not issuing because they don't like the price at which they'll have to issue them.

Benz: Right. So, you and Eric Jacobson co-authored a piece a couple of weeks back where you looked at some of the commonalities among those funds, among those munis, that were hardest-hit during that sell-off period. You looked at some areas that were particularly weak. Can you talk about some of the commonalities among those really hard-hit munis?

Sjoblom: In general, interest rate risk was a big factor. You just saw, comparing long-term funds to short-term funds and intermediate funds, long-term funds suffered the biggest losses.

Benz: So, it was unrelated to any of this chatter about problems in the muni market. It really was, in large part, just some interest rate shocks that were going on?

Sjoblom: That's correct, and there was specifically more pressure on long-term munis. There isn't as much of a natural buyer for long-term munis. We had certain programs like the Build America Bond program had siphoned off issuance from the long-term part of the market last year, and that's gone away for now. So, there's a bit of added pressure, and you have investors in general are worried about interest rate risks.

So, you've seen more mutual fund investors focus on intermediate- and short-term muni funds rather than long-term muni funds. It used to be long-term muni funds is where you get the most yields and it used to be the largest category, but now you've seen, since 2008, intermediate funds have taken a bigger share as have short-term funds.

Benz: So, Miriam, you noted that munis have had a little bit of a performance bounce year-to-date, and I guess that's a question a lot of people have been saying, when things were really depressed, "oh, there are buying opportunities here." Are you still hearing that, are you still hearing managers saying that they think there's upside?

Sjoblom: Yields, in general, on munis aren't back to where they were in arguably very low levels in September and August and October, even though they have recovered somewhat. But I'm still hearing some managers say, if you take a single A rated 10-year muni and compare it to a single A rated corporate bond, you can get comparable yields on those types of bonds, even though you get the extra tax benefit of a muni.

Benz: Right. So finally, Miriam, if I'm a muni investor or would-be muni investor, watching these headlines, watching this news flow, what are my takeaways? What are some ways to manage risk, but also not shy away from this asset class altogether?

Sjoblom: If you believe that there are credit concerns out there, and I think, we do here at Morningstar that…

Benz: It's valid, right.

Sjoblom: It's definitely a valid point, it's a tough environment. I think diversification is the number one way you combat that. That might mean not buying individual bonds, buying a fund instead of bonds, especially because in buying individual bonds, there's a lack of transparency to the pricing in that market. You have to have very large dollar amount sizes in order to be able to transact in that market. So, often you sacrifice diversification to be able to own individual bonds.

Benz: Okay. So you think for smaller investors, in particular, a fund makes good sense?

Sjoblom: That's right. Also on the diversification angle, there are some states where you would own a single-state fund, but some states have very small markets and you don't get as much diversification to invest in a single-state fund. So, I think this is still a good time to consider in national fund, and maybe forgo some of the in-state tax benefit that you would get.

Benz: So, get that geographic diversification.

Miriam, thanks as always for sharing your insights. We appreciate you being here.

Sjoblom: Thank you, Christine.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.