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Nuveen: Muni Credit Risk Is Overblown

Mike Taggart, CFA

Mike Taggart: Hi, I'm Mike Taggart, director of U.S. closed-end fund research at Morningstar. With me today is John Miller, co-head of fixed income at Nuveen Asset Management. John, thanks for joining me.

John Miller: Thank you for having me.

Taggart: Many investors like municipal bonds because they like the tax-free income that comes from investing in municipal bonds. What areas of the municipal market have been doing well lately?

Miller: Well, there has been a tremendous snapback from the pressures of a year ago when municipal bonds were of great concern due to fiscal stresses. The strongest segments of the market have really been shorter- to intermediate-term bonds and bonds with credit ratings in the A, A+ category into AAs and AAAs. So the highest-quality bonds and short- to intermediate-term bonds have been the strongest, most liquid, and most in-demand.

Taggart: And a lot of those are trading at premium right now, so investors are paying above par value for those.

Miller: Correct. A lot of large segments of the municipal market have 5% coupons, and 5% coupon bonds in the intermediate part of the yield curve can oftentimes only yield between, say, 1% and 2% in total yield. So that drives the bond price to a high premium.

Taggart: So really for that sector, that segment of bonds that's done really well lately, right now it's not offering a lot of income. But it seems to be offering a lot of, maybe, stability, or how would you characterize that?

Miller: Demand is strong, and that keeps the bonds very liquid. They have not been particularly volatile. They do offer higher yields than U.S. Treasuries, for example, and obviously, they are tax-free. So, it's mostly preservation of capital with some tax-free income even though that level of tax-free income has been driven down to, say, 1%-2% for that type of muni bond.

Taggart: Well, right now given that, for income-oriented investors who don't want to pay taxes on their income, are there any sectors right now that look good?

Miller: Yes. There are couple of segments in the municipal-bond market that have also started to improve but have lagged the broader market a little bit and still offer yields depending on the specifics in the 5.75% to 6.75%, and in some cases, 7% range. Specifically, those would be high-yield municipal bonds, BBB, non-rated, below-investment-grade-rated municipal bonds.

Taggart: So, a lot of credit risk?

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Miller: Those have some credit risk. I think some of the credit risks have been exaggerated and overblown. Also some of those credit risks have been moderated by the fact that state and local government finance has improved as the economy has expanded, and a lot of municipalities have raised taxes and cut spending.

Taggart: But for a lot of these high-yield bonds, they are not government-obligation bonds, right? They are revenue bonds.

Miller: Correct. The high-yield segment mostly consists of either dedicated tax revenue bonds or revenue bonds of specific facilities or projects like schools, hospitals, toll roads, and bridges. They are dedicated assets with a dedicated revenue stream or a tax revenue stream.

Taggart: So, for income-seeking investors who are interested in municipal bonds, it sounds like for the area that's attractive right now--in order for them to get that tax-free income--they are going to have to take on some credit risk. But the flip side of that is that right now it looks like we're at a pretty good point in the municipal credit cycle?

Miller: Yes. There are a couple of things in mind with regard to taking credit risk in the muni market. First of all, it should be done in diversified way with research and credit selection being very important. But in terms of timing of what's going on in the marketplace overall, default rates have been falling since the 2008-09 period. So, with default rates coming down, you would think that those credit spreads would narrow. But actually credit spreads are still wider than their long-term historical averages by a significant margin.

Taggart: Let's put that into perspective, too, because when you talk about default rates for municipal bonds, it's very low. It's like 1% or 2%?

Miller: For the municipal market as a whole, blending together high-quality and high-yield, it's historically less than one half of 1%. When you're talking about just the high-yield segment of the municipal-bond market, that tends to be in the area of 1% just for high-yield though.

Taggart: Then to put that into context, the corporate default rate is anywhere from 2% in a great year to 8% in a bad year?

Miller: Correct.

Taggart: So, when you talk about a bad credit year in municipals, it's still better than a good year in corporate credit defaults?

Miller: Yes, typically that's the case because even the municipal high-yield credits do tend to have some essential-services component, some essential facility benefiting a community.

Taggart: As I'm the director of U.S. closed-end fund research, I have to ask when it comes to investing in municipal bonds, closed-end funds seem to me, because of their closed capital nature, to be a good investment vehicle to put relatively illiquid securities like municipal bonds into and invest. Are there any trends there that you've been noticing in closed-end funds?

Miller: Sure. From the investor perspective, closed-end funds are another way to enhance the yield of a municipal portfolio in a relatively low-yield environment. Municipal closed-end funds are typically the funds that have high yields and are typically going to be leveraged. So, they are borrowing money to enhance those yields.

Now, that leverage does accrue in this environment; that does accrue to the benefit of the investor from an income perspective because you're taking advantage there of the steepness of the municipal yield curve. So, longer-term municipal bonds yield a lot more than short-term municipal bonds, and the closed-end fund structure takes advantage of that in enabling closed-end funds to pay out the 5.75%, 6.00%, 6.25% distribution yields over in today's market.

Taggart: This whole time you've been talking about yields and distribution yields. Just to be clear, that's before you adjust them for the tax rate?

Miller: Correct. These are tax-exempt yields.

Taggart: Excellent. Well, John, thank you very much for joining me today.

Miller: Thank you very much. Thanks for having me.

Taggart: Thanks for watching. I'm Mike Taggart for Morningstar.