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Amodeo: Long-Dated Bonds Best Muni Values

Steven Pikelny

Steve Pikelny: Hi. I am Steve Pikelny, closed-end fund analyst with Morningstar. With me today we have Robert Amodeo. He is the head of municipal investments at Western Asset. How are you today, Rob?

Robert Amodeo: Doing well. Thank you.

Pikelny: So, why don't we start off by you walking us through some of the major developments of the municipal markets in the past few months?

Amodeo: Yeah, sure. It's been an exciting time for municipal-bond investors. Indeed, we marched into this year 2011 on our heels. We had wild speculations about defaults or the potential for defaults. We anticipated a dramatic increase in supply and the fiscal headwinds were severe. And all things considered, here we are 11 months later, and the municipal-bond market has posted dramatic returns, equitylike returns. So for those investors that withstood that volatility in the early part of this year, they're reaping the benefits today.

Pikelny: What has been driving these equitylike returns?

Amodeo: Well, a couple of things. One is, certainly those speculations about defaults really didn’t come to fruition. There are pockets of weakness, especially at the local level and the smaller towns, but they are not aggregating and becoming large problems for states, at least not so far.

In terms of supply, supply really didn't materialize the way people suspected it would. The Build America Bond program was ending. That supply that was hitting the Build America Bond program was supposed to find its way into the traditional tax-exempt marketplace; it didn’t. A lot of the public projects that would have found funding through the municipal-bond market were backburnered because of fiscal stress, and there were a few other issues, as well.

Other marketplaces were experiencing a great deal of volatility. The municipal-bond market typically is viewed as a safe harbor, though it was challenged at the beginning of this year. And with those views in mind, as a safe harbor, the fixed-income asset class is offering compelling valuations within its own market, especially when you look at it in terms of relative valuations and you compare it and contrast it with other marketplaces, as well. So, with the safe harbor, the relative valuations, compelling valuations, and diminished supply, fundamentals actually are improving. When you look at the marketplace, sales tax, personal income tax, and corporate income taxes are stabilizing, and in some cases, improving. There are also real cuts in spending. All of those factors combined have lead municipal investors to enjoy equitylike gains.

Pikelny: Before you mentioned that municipalities have traditionally been kind of a safe haven for investors, but in the past year we've heard a lot of dire predictions about widespread defaults in the municipal market. Do you think that we are past this yet or do you think that this is just something that is kind of on the horizon for us?

Amodeo: Yeah, the municipal-bond market is today a good old-fashioned spread marketplace, and what I mean by that is, you need to understand what you own. You need to understand the source of revenue that's going to support the debt. You have to look at how well-diversified the economy is, whether it's reliant solely on intergovernment transfers, or what have you, all of the variabilities that are in between.

You have to understand. You need a good credit team to understand the cash flows and whether they are subject to the decision by a particular politician or whether they are supported by a well-diversified economy like utility. Or perhaps looking ahead, there are some challenges in those communities that are dominated by military spending and perhaps at risk of future cuts from the federal government in terms of military spending. So, yeah, there are pockets of weakness still, but if you understand what you own and you have a good credit team, you can find compelling valuations in the municipal-bond market.

Pikelny: So, I guess barring a worst-case scenario, how would you position your portfolio to kind of protect yourself against this?

Amodeo: We see value in the municipal-bond market in a few different ways. One, we make three decisions in our portfolio. The first is the curve, and today we think that the best value is at the longer end of the available maturity spectrum. So, for our intermediate- and long-duration portfolios, we have a curve exposure that is a little bit longer than we normally would have.

From a sector allocation, we're going to be well-diversified across sectors, but today and over really the past few years, we've liked corporate-backed obligations, the health-care sector, and transportation sector. These are sectors that may have a broad cash flow attached to supporting that debt. But we have been mostly void of that tax-backed debt in our portfolios, and we're not suggesting with that avoidance that there is a potential for them to go into default. We just think there is a better entry point ahead. We think there are better valuations ahead of us for that sector. So, right now, we're looking at essential-services revenue bonds with a little bit of a longer end of the available maturity spectrum.

Pikelny: Great, Rob. That's really interesting. Thanks for joining us today.

Amodeo: Glad to be here. Thank you.

Pikelny: For Morningstar, I'm Steve Pikelny. Thanks for watching.