Fidelity Experts Assess the Prospects for Munis
What the heck happened, and where do we go from here?
Municipal bonds have long been a sleepy part of the investment landscape. They typically have had yields below Treasuries, but after their tax-exempt status was factored in, they were higher for investors in the top tax brackets. We've long been advocates for choosing mutual funds over buying munis directly because the funds can get much better prices and offer much greater diversification.
The sleepy sector has gotten awfully rocky of late though. Worries about the recession and demise of muni-bond insurers have caused muni prices to fall, thereby pushing yields to well above Treasuries. More recently, munis have started to rally, but they are still a long ways away from their traditional spreads. To make sense of all this, I enlisted the help of three of Fidelity's top muni managers. A few years ago, we named Fidelity's muni team as our Fixed-Income Manager of the Year, and we continue to recommend Fidelity Municipal Income (FHIGX) and Fidelity Tax-Free Bond (FTABX), among other Fidelity muni picks.
Answering my questions were Christine Thompson, Mark Sommer, and Jamie Pagliocco. Christine will be speaking at the Morningstar Investment Conference in late May. I hope you can make it to the conference and join in our discussion.
1. We've seen municipal-bond prices fall to where their yields were historically high relative to Treasuries. How did we get there?
The collapsing U.S. economy and expanding crisis across the U.S. financial system caused investors and lenders to become increasingly risk averse. The Treasury market benefited from a flight-to-quality and from investors' growing emphasis on liquidity. In comparison, virtually all non-Treasury bond markets lagged.
Despite the municipal bond market's relatively high average quality, both supply and demand factors contributed to the "delinking" of municipal yields from comparable Treasury yields. Importantly, the supply of AAA rated municipal bonds declined as bond insurance companies were downgraded (due to severe losses associated with the insurance companies' expansion into structured mortgage, asset-backed, and collateralized debt markets). As the insurers were downgraded, the municipal-bond ratings were adjusted to reflect the higher of the underlying issuer's rating or that of the insurer. In many cases, where a rating agency did not maintain a rating on the underlying issuer, the insured bond's ratings were withdrawn. This increased uncertainty for investors not equipped to assess municipal credit quality on their own.
Also pressuring the municipal market from the supply side was the desire by issuers to refinance previously issued floating-rate debt with fixed-rate debt. The collapse of the auction-rate securities market and the increased cost, and limited availability, of liquidity facilities provided by banks and broker/dealers caused short floating rates to spike for many municipal issuers. This refinancing supply competed with planned issuance needed to finance new projects and to help resolve growing budget gaps.
With intended supply growing, the demand for municipal bonds pulled back. Efforts to unwind credit market leverage significantly reduced investor demand for municipals from accounts including hedge funds and other crossover investors. Lower corporate profitability also caused a number of institutional investors to scale back their interest in tax-exempt bonds. As the market struggled to find equilibrium, financially weak broker/dealers scaled back or entirely ended their involvement in underwriting and trading municipal bonds. The end result was that municipal yields demonstrated unprecedented volatility and reached levels far exceeding that of comparable Treasury bonds.
2. With a third of the traditional muni-bond-buying market gone, will we see muni spreads level out at a new level rather than their historic levels?
Events over the past year have clearly shown that AAA rated securities are not necessarily risk-free. The municipal market has revalued to reflect both credit and liquidity factors. Relative to Treasuries, the highest-quality municipal bonds (including those directly backed by Treasuries) are likely to move toward levels more reflecting their tax-benefit with a modest premium to compensate for longer-term tax law and liquidity uncertainties. For this subsector of the market, we think that yield spreads could approach more normal historical levels as broader credit market dislocation abates. However, for most of the municipal market, credit risk is likely to remain a distinguishing factor that will contribute to yield spreads spanning a range much wider than seen historically. Market factors and fundamental pressures are likely to continue to challenge bond prices. We expect yield dispersion and volatility to remain heightened relative to the past.
3. The Treasury is expected to sell a huge amount of bonds. Is there a similar onslaught of supply coming in the muni market?
By most accounts, there is a large and growing backlog of intended supply. Many issuers would like to sell debt to refinance higher-cost debt, to restructure older bond indentures and to fund new projects in an environment where most sources of revenues are falling. As discussed, actual financing costs have been high on a relative basis and many issuers are waiting for conditions to improve. Over the next two years, Federal stimulus initiatives should provide some relief and, by helping to fund some capital projects, will reduce municipal-bond supply somewhat. Overall, we expect there will be a steady supply of newly issued municipal bonds brought to the market at a pace that will not overwhelm demand. In the past year, as issuance pushed yields higher, new investors were attracted to the market. The pace of supply is likely to contribute to above average municipal yield volatility.
4. Historically, muni-bond defaults have been quite low even in recessions. Will that change this time around?
Overall, defaults are likely to still constitute a small fraction of the municipal market. However, certain segments of the market are at risk of experiencing much greater rates of default. Credit risk premiums in the market reflect greater default uncertainty. States and large municipalities are struggling with budget challenges that leave them less able to assist other tax-exempt issuers. Not-for-profit issuers face a difficult environment to raise new funds, and many have been stung by sharp investment losses. Many speculative land-secured development issues are unlikely to remain solvent given the current housing-market outlook. Bond insurance cannot mask underlying credit problems as it used to do. While the default experience of the overall market should remain low, not all municipal investment portfolios will reflect that overall rate.
5. What about high-yield munis? Are investors getting adequately compensated for the added risks?
It is hard to generalize because the high-yield municipal market is not uniform. Prior to the summer of 2007, the high-yield market benefited increasingly from a growth in demand that outpaced supply. Risk premiums narrowed across the board and became less differentiated based on sector and issuer factors. Similarly, the repricing of credit risk over the last year has been broad. We suspect that in some cases, current spreads do compensate for a bond's risk. In other cases, we expect that prices could adjust downward should a holder decide to sell or in reaction to negative financial disclosures. We have been and remain highly selective regarding lower-quality municipal-bond investments.
6. Now that California resolved its budget mess, is it out of the woods or should people avoid California munis?
Despite California's recent steps toward resolving its immediate fiscal imbalance, the state has not eliminated its budgetary challenge. Revenue assumptions in the budget are based on data gathered in December, and, since then, the economy has deteriorated further. The budget also contains provisions that require voter approval and debt market access. Our belief is that California will face liquidity challenges for many years.
The state's fiscal issues do not lead us to avoid California municipal bonds. However, they do impact our views on the appropriate valuation for California debt. California state general-obligation bonds are secured by full taxing authority of the state, and repayment of their debt service falls second only to education expenditures. Ultimate recovery of debt service seems highly probable. However, liquidity issues could threaten the timeliness of a bondholder's repayment. In California, there are a diversity of local government issuers that are managed very conservatively and have accumulated substantial levels of reserves. Our investment choices reflect research regarding credit and liquidity differences relative to bond prices.
7. Are California's general-obligation bonds more attractive than revenue bonds?
We would not say that, uniformly, general-obligation bonds are more attractive. While California's problems are significant, its long-term prospects are strong, and its near-term flexibility exceeds that of most issuers. California is one of the largest economies in the world with significant industry diversity. The state benefits from various funding sources and has the flexibility to manage costs by making tax adjustments and deferring expenditures. As their prices have fluctuated, California general-obligation bonds have, at times, compensated investors well for the uncertainty.
By their nature, in comparison to the state, revenue bonds are limited to narrower revenue streams and have less financial flexibility. In the current environment, however, many revenue credits have a better cash position and are managed with a more responsive effort to avoid financial stress. Revenue bonds can provide attractive diversification, a consideration we give strong emphasis to when managing bond portfolios.
8. Muni-bond funds offer diversification and research that individual investors can't do on their own, but they also have the ability to get better prices on those bonds, too. How much can I save having Fidelity buy bonds for me rather than buying them myself?
At Fidelity, we have a team of over 25 investors who research, trade, and manage the composition of municipal-bond portfolios. Our investment process emphasizes valuation-based strategies that balance opportunistic ideas with an emphasis on risk control. In the past year, a reduction in market liquidity has increased transaction costs and led to unprecedented market volatility. Good research is critical in this environment to avoid investment losses. Trading inefficiencies have increased and knowledgeable negotiation in buying and selling bonds can add significantly to an investment's return. Well-researched security selection, broadly diversified portfolio construction and lower commissioned transactions make mutual funds a superior choice for most municipal investors, in our view.
9. What part of the yield curve is most attractive? What sectors?
The yield curve reflects preferences across the maturity spectrum relative to the supply of bonds. Recently, demand for short maturity bonds and the supply of long maturity ones has caused the steepness of the municipal yield curve to touch levels not seen in 25 years. Although we recognize that the curve may remain steep until the U.S. financial crisis abates, we are increasingly favoring long maturity bonds in our investment strategies. Because we target overall interest-rate sensitivities that reflect that of the market, we combine long maturity purchases with shorter maturity ones to avoid an outsized increase in interest-rate driven volatility.
Our sector preferences reflect our "bottom-up" research effort. Given economic uncertainty, issuers with revenue flexibility are our favored choices. These span a number of sectors including essential service utilities, educational institutions not suffering large investment losses, and health-care providers with pricing influence. In selecting tax-backed issues, we favor issuers with diversified revenue sources and regions less impacted by the housing downturn.
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Russel Kinnel has a position in the following securities mentioned above: FTABX. Find out about Morningstar’s editorial policies.