Taxable Managers Finding Value in Munis

Miriam Sjoblom: The last couple of months have shown us that you don't need a rise in defaults for municipal bond funds to lose money, and whether part of that was Treasury-yield-related or in part it was due to outflows, I think liquidity is a big issue for the municipal bond market and for fund shareholders. Can you talk a bit about how your portfolio managers are dealing with liquidity?

Rafael Costas: Sure, it's been very challenging as you can imagine. But we also lived through a period like this not much longer than two years ago with a panic of '08 when we and the rest of the world essentially were going through the same kind of crisis in terms of people hiding away from investments and just essentially buying Treasuries and gold. So, we have recent experience, and it's not the first time that our portfolio managers have gone through a recession or a sell-off period. So, we do a lot of the same things.

You have these bonds in the portfolio that are call prerefunded bonds, pre-re for short, that essentially the way the mechanics work end up being municipal bonds that are essentially backed by an escrow of Federal Securities, so they are AAA. They have short maturities left, and those are among the most liquid things you can have out there. There is also a proportion of the funds that are been in very high natural AAA or AA qualities. I know people are skeptical of AA or AAA munis based on what they read in the paper, but they are out there.

So, you try to move those around. You also have increasing your cash cushion a little bit. The first half of this overall panic was really in November, and once that settled out towards the end of the year, we had also made a decision that, like I just said a few minutes ago, the market might still be fragile enough to maybe want to increase cash a little above our normal levels.

There is also strategic selling that you can do in order to generate some tax losses in the fund that you can use in the future to offset gains, but that also allows you to essentially swap lower coupons for newer coupons in the market that are now in the 6%, 6.5%, 7% range, and 8% in some very rare and small cases that we have identified. When the funds are yielding somewhere in the 4.5% range right across the industry, and you can buy bonds at a lot higher than that at 6% or 6.5%, the benefit ultimately will be that you can also raise the dividends in the funds in the coming weeks and months.

Sjoblom: I think some municipal managers have been criticized for defending their market as being too close to it or too self-interested in doing so. But lately, we've seen more taxable bond managers coming out and speaking in support of the municipal bond market and finding some value there. Is that something you are seeing, as well?

Costas: Yes, we are, and that's what we call the crossover buyers. Technically, they are buyers from other markets that are nontraditional municipal participants, but when municipals or any asset class gets as cheap as municipals got in December and January now 2011, as they look at options for them to invest some of their portfolio, they start looking at munis. You can buy a California GO bond at more than 5.5%--6% not that long ago. That compares pretty well to buying a Treasury bond at 4%-4.5%, and this 6%-6.5% or 6%-6.25% that you can get in munis is tax-free.

And they have done it before. This happened in 2008 and 2009, and when we had the California crisis, when the governor got recalled in 2003 and California bonds got really cheap, they also did it then. Some of our own taxable funds at Franklin have been doing that and they are comfortable doing it with us. Obviously, we're a very big player in municipal bonds. So, they come through us and through our desk to make these really great investments for their funds.

So, by now, this is kind of an old-hat thing for them. It's a lot easier for them to come in a period like the present and ask again about where the opportunities are, and they generally buy the higher-quality kind of bonds out there. But that has ended up providing pretty good support to the market lately, and it has helped ease that panic feeling that we had some three or four weeks ago at the beginning of January. And the muni market actually had an nice little rebound lately to start offsetting the big sell-off that we saw in late 2010, early 2011.