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Avoiding Potholes in Municipal Bonds

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm joined today by Mark Sommer, he is the portfolio manager of several Fidelity municipal bond funds. We're going to look to see what kind of values there are in the municipal sector, and what risks investors should keep in mind.

Mark, thanks for joining me today.

Mark Sommer: Thanks for having me.

Glaser: So let's talk a little bit about muni credit risk first. This was something that was really high on investors' mind for a while, and it's re-emerged with the bankruptcy in Stockton and with potential municipal woes elsewhere. How concerned are you about credit risk, and is this an even concern when you look across the different sectors of municipal bonds?

Sommer: Jeremy, it's definitely out there. I think that in Stockton, the issue there is whether or not they are going to pay pensions at the expense of bond holders, and then at the other end of the spectrum in Rhode Island, the state actually passed legislation to protect GO bondholders, and that came into play in Central Falls bankruptcy. And while you could have a resolution in Stockton that could set a precedent for the rest of the state, it's not clear at all that this would carry over to other states.

So, one of the underlying themes--both in Stockton, Illinois, Puerto Rico--is the underfunding of pension liabilities. One of the silver linings here is that pension reform is finally gaining some momentum, both at the state and local level. I think from an investor's standpoint, the key will be avoiding the most troubled credits. We don't expect there to be waves of defaults or restructurings, but there are definitely going to be potholes to avoid.

Glaser: So it sounds like those credit issues will be relatively contained. You mentioned California being a potential issue, Illinois, and Puerto Rico, are there other areas that you're avoiding for credit reasons?

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Sommer: I think it's all a function of valuation. So there have been times over the last several years where California and Illinois, we've been buyers of their state debt, and other times when we've been sellers. It has been more watching the valuations and how much you get compensated for the volatility of the risks in those credits.

Glaser: So let's talk about valuation a little bit more, then. Where do munis, or where do you see muni valuation compared to Treasuries, compared to other fixed-income investments? Does today like an attractive entry point?

Sommer: That's always a hard one to ask, especially given how special Treasuries are trading at this point in time. I'm not sure that's the right benchmark anymore. Treasuries are so incredibly expensive. But when you look at munis relative to similarly rated taxable investments, there are many factors that are on the positive side for munis. Obviously, they benefited from the higher tax-rates that are now in effect, and you have a new 3.8% Medicare tax that applies to non-municipal unearned income, and that's a huge positive for muni bondholders. You have state revenues that are recovering, an improving housing market, a relatively manageable supply in our market. And then you have from 10 to 30 years, a relatively steep yield curve in munis compared to the Treasury and other taxable curves, and so all these things are quite positive for munis on a relative basis.

Glaser: So when you're looking at where to position your portfolio--you mentioned that steep yield curve--are you taking that extra maturity, you're going out on that curve? Is that where the best value, or is it finding those cheap credit risks, potentially, to find extra yield there?

Sommer: You're asking kind of the key question that all frustrated investors in our market are currently asking. They look at the level of yields, we're in this very scarce yield environment, and there's an increasing impatience, and those are the two alternatives that investors have for increasing the yields in their portfolios. As you remain in a prolonged period of falling rates, tightening spreads, it's a time when investors take risks. And we've seen this over and over again, and the most dramatic example was pre-2008 when we had a similar environment with rates falling, spreads tightening, investors taking risk.

From my perspective, I think the answer, when you're not being compensated for risk is, how do you take less, not how do you take more. That's not to say there are no opportunities. I think we're finding the biggest opportunities in the health-care sector. Obviously with a very constrained reimbursement environment, both from the government and private insurance companies, there are going to be winners and there are going to be losers, and we have a great health-care team who seem have to a knack for finding the winners in this environment. But I'm not subscribing to broad risk-taking, given where yields and spreads are.

Glaser: So if you're trying to manage your risks, what are some of the things that would keep you up at night? If it's not generalized defaults, are you worried about inflation? Are you worried about rising rates? What are some of those big potential pitfalls for muni investors?

Sommer: I think that the biggest risks are exactly the ones you're focused on. There is rising rates, there is the idiosyncratic types of risks that we've been talking about--because there definitely have been some highly publicized issues, which have hurt muni valuations in those credits across the country. There's the potential for contagion, [but] I think fortunately there aren't many credits that have that potential. I think you have that in Puerto Rico. And then you have the risk we were just talking about, reaching for yield, compromises that investors are making in structure in different covenants, in extending the duration of their portfolios.

Glaser: So how do you think about interest rate risk?

Sommer: The way that we think about managing interest rate risk is by being very disciplined. So we have benchmarks for all our funds, and we're pretty good about keeping the funds' duration aligned with those of the benchmarks. We look at various scenarios. The underlying philosophy is that investors choose a fund based on the amount of risk that they want to take. If they choose an intermediate fund, for example, we don't want to second-guess them by shortening the duration on that intermediate fund. They can always move into our short-intermediate fund if they're looking for less interest rate risk. So we're trying to align with what we think our investors expect.

But there are things that we can do to mitigate the potential for rising rates in our funds. One of the ways we do that is by having a more barbelled structure across the yield curve, emphasizing longer maturity securities and shorter maturity securities. We would expect that the yield curve would flatten when rates do in fact rise, and that type of structure would mitigate the impact of rising rates.

And the other thing you can do on the margin is to manage your liquidity so that, when rates rise, inevitably you see investors leaving the asset class, and you need to be able to source liquidity to meet those redemptions. This was a very important factor, both in 2008 and in the wake of Meredith Whitney's comments in late 2010, where we saw significant redemptions in our industry, and those who had adequate liquidity were much less impacted by those periods, and the rising rates that we saw through both of those periods. Again, on the margin, how you choose your coupons--ultimately if rates go to much higher levels, that's going to become a very important factor in determining muni valuations.

Glaser: You mentioned idiosyncratic risk. How do you protect yourself against that?

Sommer: With respect to idiosyncratic types of risks, the only way to manage that is to have the resources to keep track of all the names that you own, and all the names that are coming to market with issuance. At Fidelity, we're fortunate enough to have those resources. We have close to 20 muni analysts. We have a legal team that's focused on the debt that our group buys. We have four traders that are our eyes and ears on the market. The key there is just to have lots of eyes on everything that we buy, everything that we own, to try to keep track of those credits, because the way that idiosyncratic risk in portfolio arises is, you buy something and you put it away and you don't look at it for a while. And you do that in a situation where you don't have the resources to kind of keep that ongoing surveillance.

Glaser: Are you worried at all about a sector-wide contagion?

Sommer: I think with respect to contagion risk, it's really, really tough to manage. And as I said before, fortunately, there are only a few credits that even have this potential to have broader impact on the muni market. You've got the potential for adverse tax reform. These are very difficult for us as muni managers to position against. This is going to impact potentially a wide swathes of our market, and quite frankly that's just a very, very hard thing to do.

What we can do with respect to reaching for yield is, as I was saying before, not getting sucked in by the momentum and the herd mentality of this type of environment. Maintain your standards. I think that you're not giving up much in yield to avoid these risks, and we're not that far away from 2008. In 2008, you had this incredibly wide dispersion of returns across investment-grade muni funds that were previously thought to be relatively similar. I think the managers that fared the best in that environment were those who maintained the most discipline in the 2006-2007 type of period, just prior to the market crisis. And we're trying to keep that lesson in the forefront as we think about risk-taking now.

Glaser: So it sounds like there could be some value in munis, particularly at an after-tax basis, but investors should be absolutely sure they are getting paid for any risk that they are taking on.

Sommer: Yes, I think that's a nice way to summarize it.

Glaser: Well Mark, I really appreciate you taking the time for talking with us today.

Sommer: Well, thank you for giving me the opportunity.

Glaser: For Morningstar, I'm Jeremy Glaser.