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Don't Write Off Munis Out of Hand

Christine Benz

Christine Benz: Hi. I’m Christine Benz for Municipal bonds have been struggling so far this year, and investors have been fleeing the asset class. Joining me to provide some color on what’s been going on in munis are two of Morningstar’s municipal-bond experts. Eric Jacobson is a senior fund analyst, and Candice Lee is an associate credit analyst for Morningstar.

Thank you both for being here.

Candice Lee: Thank you.

Benz: Candice let’s start with you and do some stage setting. We’ve seen some very sharp price declines in municipal bonds recently. What’s been driving them down?

Lee: So far this year we’ve seen significant outflows out of muni mutual funds. The majority of those outflows actually occurred in June. In our opinion, the outflows in June actually are a reflection of the flight from credit risk and interest-rate risk for municipal-bond investors. June happened to be around the same time that the worries about the Fed tapering program started to take hold, so that certainly introduced an element of interest-rate risk to the market. Furthermore, mid-June was also when the Detroit emergency manager [Kevyn Orr] presented his debt-restructuring plan, which proposed an unprecedented treatment of general-obligation debt as unsecured. That certainly caused some reverberations in the market from a credit perspective, and so we think the confluence of those two events certainly contributed to those major outflows in June.

Benz: It was a perfect storm in a lot of ways.

Lee: Right.

Benz: How concerned should municipal-bond investors be about the Detroit bankruptcy filing? Do you think it will have a widespread reverberation throughout the muni market? What do you think are the implications for investors in, say, a broad-basket municipal-bond fund?

Lee: Certainly with all the headlines that Detroit is making currently, that understandably spurs some fears about the whole municipal asset class. But I would actually urge investors to caution against treating the entire muni asset class as being monolithic because I think the specific economic, demographic, and financial ailments that have been facing Detroit for decades are not really applicable to the market as a whole.

Broadly speaking, we’ve actually been seeing a lot of signs of improvement across the U.S. For states, we’ve actually seen both the number and the magnitude of state budget gaps decreasing significantly in recent years. The magnitude of the gap has been roughly halved between fiscal year 2012 and 2013. This is owing to stronger tax collections among states, and then also the gradually recovering housing market and labor markets have boded well for both states and local governments.

That being said, going forward, we are still concerned about some major issues that municipal governments have to say, particularly with regard to pensions and OPEB funding.

Benz: What is that?

Lee: OPEB meaning Other Post-Employment Benefits, such as health-care benefits for government workers. We’ve already seen the effects of pensions and OPEB on places like San Bernardino, Calif.; Chicago; Illinois; and of course, Detroit. Specifically with Detroit, we think that the results of the bankruptcy proceedings are actually going to have very far-reaching implications in the muni market as a whole, with regard to the prioritization of payment to creditors versus pensioners as well as the treatment of general-obligation debt going forward.

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Benz: Eric, I’d like to discuss the interest-rate shock with you that we had in that May/June period. It was really a stress test for bond funds of all types. Let’s talk about within that muni universe when you look at various funds, which fund types tended to get hurt the worst in that period.

Eric Jacobson: The longest-duration funds certainly took the brunt of the pain. [Duration is a measure of interest-rate sensitivity.] Interestingly enough, they were hurt more so even then Treasury funds and other taxable areas, where you would expect there to be a lot of interest-rate risk.

Benz: A lot of the issuance in the municipal-bond space tends to be in that long maturity area.

Jacobson: That’s right. The largest cohort in the Barclays Municipal Bond Index is, in fact, the longest part of it that has 20% of the issuance. So it makes a big difference there. Investors tend to flock toward a lot of the longer-maturity bonds, because they have the high coupons.

Benz: Yields are a little better.

Jacobson: Yes.

Benz: We saw this exodus from municipal-bond funds happening in the third quarter; very steep outflows. Let’s talk about the implications, Eric, for funds because I know in contrast with some other markets, municipal-bond funds are actually really big players in that market. Do you think there are any implications for muni-bond prices if investors continue to dump municipal bonds?

Jacobson: Well, it seems pretty clear that a lot of the redemptions that are taking place in the mutual fund universe are definitely affecting how municipal bonds are trading. The market is comparatively illiquid relative to some others, and it plays into that issue. Not only do you have that long-maturity issue that you raised before, but you have this question of liquidity. Even if you have a modestly small amount of redemptions compared with the size of the entire muni market, if those were the bonds that are trading, they are the ones that are going to set the marginal price.

Benz: Eric, I would like you to talk about whether this dislocation in muni-bond prices has potentially created any opportunities. I’m not asking you make an interest-rate forecast because it’s obviously impossible to do. But what do you see when you look at munis today, and could there potentially be opportunities for investors who are willing to kind of be bargain-shoppers at this time?

Jacobson: I definitely want to isolate that interest-rate bet because I do think that that’s something that’s on a lot of people’s minds right now. We don’t know quite yet when this tapering issue may or may not resolve itself. As you can see from what we had over these couple of months, investors tend to shoot first and ask questions later. I don’t want to steer anybody too heavily into long-maturity municipals just based on that issue. However, as you know, the prices having gone down so much on municipals now do arguably represent some value in the marketplace. If you look at the ratios for municipal yields to Treasury yields, for example, and you look at what the tax-adjusted yields are on municipals, when you compare them with taxable bonds, they’re a lot more attractive than they’ve been for a long, long time. That really argues in favor, at least as a sector in favor of municipal bonds.

Benz: Especially I would imagine if you’re one of those investors who is in the highest tax bracket and possibly even in that Medicare surtax band, it seems like things might align even more in favor of municipal bonds.

Candice, I’d like to hear from you. It’s obviously a nervous environment for muni-bond investors. Do you have any guidance to share on how people should be thinking about this environment, some steps that they might take as they navigate?

Lee: Again, I think with the demise of the bond-insurance industry, it is very important to view the muni market as being varied as opposed to being like a monolithic asset class. I think from our perspective we like to probably reiterate the importance of doing your due diligence and really getting down to fundamental credit analysis to really understand where the risks and benefits are for muni investors.

Benz: Eric, I would guess that you would say, if you’re not comfortable doing that due diligence, definitely go with a well-diversified fund.

Jacobson: Absolutely.

Benz: Well, thank you both for being here. It’s obviously a really challenging time for muni-fund investors, muni-bond investors. It's great to hear your perspective.

Lee: Thank you.

Jacobson: Glad to be with you.

Benz: Thanks for watching. I’m Christine Benz for