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High-Quality Muni Bonds Holding Up Well

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Muni bond investors have been wondering how their portfolios have been performing through all the market turmoil. To answer some of these questions, I'm here today with Dan Loughran. He is the senior vice president and senior portfolio manager of OppenheimerFunds.

Dan, thanks for taking the time today.

Dan Loughran: Hi, Jeremy. Thank you for having me.

Glaser: So, the first question I have is, how have the muni bonds been performing through this market turmoil? Have they held up pretty well?

Loughran: Yes. The muni market has held up fairly well, considering what we're seeing go on in the equity markets. In fact, it's been encouraging to see high-grade muni bonds move in step with Treasury bonds, rallying in price after the downgrade of the sovereign credit rating.

Now, high-grade munis have improved in price since the downgrade, but only slightly. So they have trailed the upside of the Treasury market but at least encouraging to see them moving in the same direction.

In terms of lower-rated or high-yield sectors of the muni market, those bond prices have fallen slightly. Again, it's nothing in comparison to what we've seen in the equity markets or, even for that matter, what we've seen in corporate high-yield bond markets. But they are off slightly. Again, this is part of the old risk-on, risk-off trade. Monday was a big time risk-off trade.

Tuesday, though actually with the equity markets improving, corporate high-yield bond markets improving, I expect to see some stability to return to the high-yield part of our market. One particular place where investors often look are the muni exchange-traded funds. There was a high-yield muni ETF and that was down sharply in price Monday. That's rebounding Tuesday. I think that should help alleviate some of the fears in the lower-rated parts of the muni market, but the high-grade part of the market, as I've said, I'm pleased to see is has been really moving in step with Treasuries.

Glaser: So, let's take a closer look at that downgrade. Do you have any thoughts on S&P's downgrade of the sovereign debt of the United States and what impact that will have on the potential ratings of the individual municipal bond issues?

Loughran: Yeah. I guess, first, just my general view of the downgrade itself, I completely disagree with the move by S&P, and I remember, of course, Moody's and Fitch affirm their AAA ratings. I agree with them. I also agree with Warren Buffett, who Monday came out and said that the U.S. Federal government should be quadruple-A-rated. To me this is just S&P moving a step closer to becoming irrelevant.

That all started with their overrating of mortgage securities some years back. For years it had underrated muni bonds compared with other fixed-income sectors. So, I think certainly the firm gets a lot of press and notoriety, but their actual performance over the last several years leaves a lot to be desired; again, just another step towards irrelevancy.

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Think of it. It has France as AAA rated and U.S. only AA+. Who would you rather lend money, to" the U.S. Federal government or France? I think it's off-base and unwarranted. Now, as far as what happens in the muni market in terms of credit ratings. S&P will then naturally downgrade some muni bonds that are directly tied to the sovereign rating, and that specifically is, firstly, pre-refunded muni bonds. These are bonds that were initially issued by state or local government. The bonds were refinanced by the borrower, but because they weren't callable, they sold their refunding deal to buy a pot of Treasury securities to back those old bonds.

So, essentially in those cases pre-refunded bonds are backed by Treasury bonds. That's why they will be downgraded in step with S&P's move on the sovereign rating. But just like Treasury bonds, prices of those prerefunded muni bonds have actually rallied since the downgrade, and that to me is another telling sign of how the market disagrees with the S&P rating downgrade.

Think of it, when most credits are downgraded, bond prices usually fall; market yields increase. It costs more for that borrower to borrow money. In this case, we're seeing the complete opposite. We're seeing Treasury bonds and prerefunded muni bonds rally in price. So their borrowing cost is actually going down even though their credit rating was downgraded. So the markets are telling you that they disagree with the action itself.

I guess the next step for the rating agencies would be to look at other muni ratings that aren't necessarily directly tied to the Federal government, but are heavily influenced. They may consider states like Virginia and Maryland, just with significant Federal government presence in those states. So we could see some downgrades on stuff like that.

Again, we're talking of going from AAA to AA+ on some of those credits. So In my view, it's not going to be material. In fact, the muni market itself despite some of the headlines we saw late last year with Meredith Whitney forecasting doom and with headlines associated with the sovereign downgrade, the muni market itself actually remains extremely stable when it comes to credit performance. The borrowers are, in fact, gaining principal and interest back on the money that they borrowed, and in fact, we've seen defaults actually decline this year in the muni market despite the gloom and doom forecasts late last year. Defaults peaked in the muni market in 2008 and even in that peak year, they were still less than one half of 1%.

So our market, the muni market has a great history, continues to demonstrate that actual credit performance where the borrowers, the state and local governments, will take steps to secure their credit profile. They will cut spending, raise taxes before they consider defaulting on their bonds, and in fact that's we've seen.

We've gone through the budget-balancing process at the state level. It got a lot of attention in the media. There were what seemed to be scary headlines, but in fact all states delivered a balanced budget for fiscal year 2012. Guess what, they are paying principal and interests on their bonds. They have cut spending in other places on the state level. For fiscal year 2012, total spending is about 2.7% below 2008 levels. Again, that's sometimes a difficult political matter, but as far as us lenders as bondholders, that's a good thing.

Glaser: So, looking at the pricing outlook and the supply and demand balance in the municipal market, would you expect that at least the higher-quality part of the market will continue to rally, or do you think that that rally has already occurred?

Loughran: Yeah. I think as long as there are fears of risk in the world, whether that's equity market volatility or foreign sovereign debt default concerns, I think high-grade munis will participate in the flight-to-quality trade, which is basically what we saw Monday. Again, that's abating Tuesday. So, to me this is encouraging though that high-grade munis are being considered in the flight-to-quality bucket, and that wasn't the case, say, in 2008 when even high grade munis were considered a risky asset.

Glaser: Dan, thank you so much for joining me today.

Loughran: Thank you very much, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.