Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors, worried about tax efficiency have been keeping a close eye in the municipal-bond market. I'm here today with Jeff Westergaard; he's Morningstar's director of Municipal Analytics. We're going to get his take on the credit quality in the muni space and also if muni bonds look attractive compared with other fixed-income asset classes?
Jeff, thanks for joining me today.
Jeff Westergaard: You bet. Thanks for having me.
Glaser: Let's take a look at just the general credit landscape for municipals. A few years ago, there were some highly publicized reports about the coming flood of municipal bankruptcies and that this asset class was potentially very unsafe. What's happened of that? Where do you see the state of the credit market right now?
Westergaard: We don't want to overlook the fact that the recession of 2007, 2008, 2009 was really the worst economic period that the country has faced since the Great Depression, and that certainly had a severe impact on the fiscal health of municipal government issuers. But the fears of the municipal market being the next shoe to drop and apocalyptic bankruptcies and defaults simply have not proved to be true. In our opinion, Morningstar believes strongly they will not prove to be true. In fact, if you look at the fiscal health, particularly at the state level of government issuers, it's improved tremendously since the low point of the recession in 2009.
Glaser: Let's take a look at across on these different issues and different bond types. Are there some that seemed to be better-positioned from a credit perspective than others?
Westergaard: Well, yes. We really think that if you focus on the state-level issuers as opposed to local governments within those states, states tend to have some very significant advantages, particularly in terms of financial flexibility and what they can and cannot do, particularly on the revenue side. For local governments within a state, oftentimes they are dependent on the state government for transfers of funds, et cetera, and plus they are generally much smaller entities than a state is.
So, states have a leg up, if you will, over local governments just due to both size and the legal structure the way that state governments determine what local governments can do.
Glaser: Let's look at the kind of yields you can get in the municipal market right now. Do they look, from an historical level, attractive compared with other options, or are there just not a lot of values there?
Westergaard: Well, rates on an absolute level are low, and I don't think that will come as a surprise to anybody. The question always in a fixed-income instrument is, are rates going to go lower or are they going to go up? If they go up that tends to impact negatively the value of the bond you hold. That being said, you can also look at rates on a relative basis and traditionally in the municipal market you look at municipal-bond rates compared with U.S. Treasury rates.
So on an absolute basis, rates are low, but they have been relatively stable for over the past 10 to 15 months in any rate. On a relative basis they do look somewhat historically attractive compared with Treasuries.
I guess the question is: Would rates go up, would they go up dramatically, and what would be the driver of that? I think that most economists would say that with the Federal Reserve in what appears to be an extended period of easy money, that the likelihood of [rising rates] is probably fairly low at least for the near future.
Glaser: What about supply and demand? For a while, there was a lot of talk about this imbalance that was impacting pricing. Have we seen kind of this new issuance come into the market that's helping to alleviate some of that?
Westergaard: Again if we kind of go back to the financial crisis, the beginning of modern history in the muni market anyway, you had a drop-off of significant quantity in issuance that really hit in early 2011, and there are a couple of reasons for that. So, post crisis you had some government statutes that came into being that in particular promoted the use of taxable municipal debt, which was relatively new type of feature in the market, but those expired at the end of 2010.
So, in early 2011, you had a severe decrease in issuance in the front part of the year. It started to ramp backup in the latter part of the year and then in 2012 issuance was actually been pretty close to recent historical averages. So, issuance has been pretty healthy. The predominant reason for that though goes back to our discussion a moment ago of low rates, and that's refinancings by municipal issuers. So they are selling new issues that take out older higher-interest-rate, higher-cost issues, and that's really been the driver of volume this year.
Glaser: So it's not a sign that necessarily states are taking on a lot of new debt, it's more of that retirement [of current debt]?
Westergaard: Yes, it's debt management.
Glaser: You mentioned that states are a good credit bet. What are some of these states that you think have some of the strongest profiles right now, and what are some states that you think would be better avoided?
Westergaard: Well, the one easy one to pick as a positive would be Texas, and there are a couple of reasons. Texas weathered the recession better than most states; certainly of all the large states they came through the best. They didn't have any of the pronounced real-estate-related problems that you saw in, say, Florida or California. In addition to that they've got oil revenues, which tend to be right now, with the price of oil back up a little bit, increasing. And [the state has] consumption-based tax sources, so sales taxes primarily have also been rising due to the general health of the economy there. So Texas is an easy one to point to as being in a good position.
California is kind of ongoing soap opera, if you will. They've always got something going on, and it always seems to be related ultimately to kind of the dysfunctional state of the state government. That being said it's the largest state in the union in terms of population and in terms of economy. And we don't really look for any think systemically bad going on in California.
On the other side of the equation, Puerto Rico, well, not a state, it's a territory. Puerto Rico has some serious issues in our opinion. And then here in our great state of Illinois, the pension issue remains a very, very serious drag on state finances and one that right now doesn't seem to have an easy solution. So, I think speaking at a high level, be very cautious about Puerto Rico and pretty cautious about Illinois.
Glaser: So, it sounds like there might be some relative opportunity in this space, but definitely do your homework on the credit side before jumping there.
Westergaard: Yes, I think that would be a safe statement.
Glaser: Jeff, thank you so much for taking the time today.
Westergaard: You bet. Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser.