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Muni Sector Has Started to Heal

Local finances are still strained and stressed, but the sector has fundamentally started to improve, says PIMCO's John Cummings.

Miriam Sjoblom: Hi, I'm Miriam Sjoblom, associate director of fund analysis at Morningstar, and I'm here at the Morningstar Investment Conference with John Cummings, who is the head of PIMCO's municipal bond desk. Thanks for joining us, John.

John Cummings: Thank you. Thank you for having me.

Sjoblom: At the beginning of this year, investors were very nervous about municipal bonds. They were leaving municipal bond funds in droves, and we saw some pretty steep losses, in muni bond terms, for some of these funds. Now fast forward, it's been six months, and it seems there's been a recovery in the market. Where are we today?

Cummings: Well, we had our first week of positive inflows this week, so probably every municipal bond man is going to have a huge party--first week after, I think, 29 weeks in a row. We've had a pretty strong rally. We have moved back up with the Treasury market. We've seen quite an increase in state revenues on the personal income tax, sales tax, and corporate income tax are up slightly. So the whole fear and panic seems to be going away, though we did get a little negative publicity earlier this week.

We've seen a little shift from, "Oh my goodness, the entire municipal bond market is going to go off a cliff" to people becoming more rational. I think people forgot that the municipal bond market is a market of bonds. Everybody kept calling it the muni market, and every muni bond was considered bad. I think people are starting to understand it's no longer a rates market, but a credit market and that not all the bonds are bad. Everybody said, "Oh my God--muni bonds are bad." There will be some losers. Predominantly there are winners. There are winners and losers. That's part of a portfolio manager's job is to pick the winners and not own the losers.

But there will be some losers. Local finances are still strained, stressed, and could be problematic going forward, but the sector fundamentally has started to heal, improve.

Sjoblom: Well, you mentioned it's not a rates market, at the same time when munis sold off late last year, early this year, we did see Treasuries sell off at the same time. Recent rally, Treasuries have also rallied. To what extent do municipal bond fund investors need to be concerned about interest rate risk?

Cummings: They do. It's interesting, I gave a presentation last night and somebody asked me about municipal bond risk, and I broke it down. There are two types of risks in a municipal bond. There is interest rate risk and credit risk. So it is a bond, so you have to be cognizant of the interest rate risk. PIMCO as a firm is not that positive on duration interest rate risk. We prefer credit risk right now. We are underweight duration in our portfolios. We are concerned about a possible or an increase in interest rates. Investors in fund should be cognizant they have interest rate risk and credit risk, and the portfolio manager has to manage both. It's not just municipal risk.

Sjoblom: Okay. It seems another big story this year and something that's been supporting the market is that issuance has just dropped way off, and there's some debate about whether issuance is going to stay low for quite some time to come or whether there is a big deluge of supply that's on its way?

Cummings: Well, when you talk to state and local finance officials, they talk about the new fiscal conservatism and austerity, and you're not seeing any finance officials on the state and local level wanting to engage in any large projects that'll generate big headlines and say we're going to borrow and spend. We're seeing cutbacks in spending, so there's cutbacks in borrowing because they don't want to engage in any capital projects.

I don't see any big deluge like, "Oops," it pops up like we forget to tell you there's $50 billion this week, but eventually it will start to increase again. You could actually make the argument that the market is supply-starved. It has gone off such a cliff that it could use more supply. The secondary trading volume has dropped dramatically. I don't see any big jump in the near future. We're not going back to $400 billion anytime soon. We're going to kind of muddle along with a $200 billion, which is still a decent amount of bonds.

Sjoblom: Just in terms of what investors can expect investing in the muni market--we saw the selloff last year, a big recovery this year. Are we just more prone to the sort of ups and downs in this environment?

Cummings: Well, unfortunately I think you're going to see that the volatility will stay relatively elevated. Now, you hope as an investor in munis you're not going to get this continued bouncing up and down in the market--these plunge down, gap back up again; that's very unsettling for investors.

But I think on the margin, volatility will stay elevated, but not to the degree we saw at the end of 2010 and '11, but there's less liquidity in the market. We are subject to headline risk. So yes, volatility has increased, and I'd say it's going to stay elevated for a while.

Sjoblom: What types of credits are you most comfortable with in your portfolios?

Cummings: Well, we still like essential service bonds where there is a dedicated revenue stream, water bonds, sewer bonds, university bonds, state university bonds, we're a big fan of. We still like select health care. We still like a small allocation to tobacco bonds. We're more in favor of big state GOs and essential service bonds than small local bonds. Small local bonds make me nervous. They're tough to get the financials. They are subject to shocks by cuts in state funding. That's where I think we could see some trouble with small municipalities; that makes me nervous.

Sjoblom: Okay. Well, thanks for joining us today, John.

Cummings: Thank you.