Munis: A few rough spots amid improving fundamentals
May 23, 2013
- Recent credit downgrades and bankruptcy proceedings among local governments are largely exceptions, amid a broadly improving credit environment.
- Munis still present attractive yields on a tax-exempt basis, particularly when considering that federal tax rates have gone up.
- Clients concerned about credit risk should focus on high-quality, broadly diversified muni bond funds with low expense ratios.
Recent muni credit events, including the credit rating downgrades of the Commonwealth of Puerto Rico and the State of Illinois and the ongoing bankruptcy proceedings of the City of Stockton, California, have set some muni investors on edge. To shed some light on these developments and how they affect the muni bond market, we spoke with Ron Mintz, a principal and senior investment analyst in Vanguard Fixed Income Group (FIG), and Nathan Will, an investment analyst in FIG.
In recent months, we've seen some high-profile credit deterioration among a few state and local governments. Do you think the recent credit downgrades and bankruptcy proceedings indicate wider issues in the muni market?
Ron Mintz: No, we don't think the recent credit events are a sign of worse things to come. While the economic environment is still tough, the municipalities experiencing major credit problems continue to represent a few isolated cases. Also, the issues faced by these local governments have been known, and either those risks have largely been priced into those bonds or their bonds were credit-enhanced and, therefore, didn't trade based on the issuer's credit status.
Puerto Rico's credit rating was downgraded to a notch above junk at BBB– by Fitch and S&P as the commonwealth's already challenged economy faces further headwinds from deeper budget cuts and new austerity measures.
S&P cut Illinois's rating to A– as the state continues to grapple with how to manage underfunded public employee pension obligations.
In California, attention has returned to Stockton, where a judge ruled that the city could proceed with its bankruptcy filing.
The fiscal challenges facing local governments are real and should not be ignored. But on balance, tax collections continue to improve, bolstered by stronger housing prices and improvements in the U.S. economy.
Speaking of pension liabilities, the Stockton bankruptcy proceedings have been in the news as state-law-protected pension funds are being brought to the negotiating table. Do you think a ruling against pension funds would inspire more cities to file for bankruptcy?
Nathan Will: We are monitoring the situation in Stockton very closely, primarily because the outcome of this case could set a very important precedent. Muni bankruptcies are so rare that there is relatively little precedent on how to apply the law to most circumstances, let alone to state pension provisions. In this particular case, bond insurers and others are challenging the Stockton bankruptcy on the grounds that CalPERS, the city's largest creditor and the state's largest pension fund, is receiving preferential treatment because payments are still being made to the pension plan while bond obligations are allowed to default.
What could a ruling against pensions mean? Well, one way of looking at the case is that if there are cuts to pensions, other cities could use it as a model for restructuring their own obligations. On the other side of it, pension funds such as CalPERS would view this precedent as a risk to assets that would have to be taken into consideration going forward.
What do you think is the likelihood that pensions will be cut?
Nathan Will: The tricky part of Chapter 9 bankruptcy cases is that decisions are dependent on the judge presiding over the case. Rather than trying to determine whether pensions are going to be affected, we think it is more constructive to perform a sensitivity analysis on the severity of the scenarios. The degree of the impact will depend on the final decision. And we are going through that analysis right now.
What should financial advisors tell clients who might be concerned about their muni bond investments?
Ron Mintz: Relative to other bond sectors, munis still present attractive yields on a tax-exempt basis, particularly when you take into consideration that federal tax rates have gone up. In high tax states, the exemption from state income tax is an added benefit. Munis could be integrated as part of a tax-management strategy.
Advisors whose clients are worried about credit risk should encourage investors to consider high-quality, broadly diversified muni bond funds with low expense ratios. If there is anything that the 2007–2008 credit crisis has taught us, it is the importance of diversification. And in the current low-yield environment, keeping tabs on cost is more important than ever.
While the fiscal prospects of state and local governments have improved, long-term challenges such as retirement obligations, revenue constraints, and increasing service demands continue to pose headwinds to credit fundamentals.
In such a tough credit environment, how does Vanguard look for muni opportunities?
Nathan Will: Research is one of the main pillars of our process. We have a highly collaborative credit research approach that integrates input and feedback among portfolio managers, analysts, and traders. This process helps us identify and react quickly to opportunities that may present themselves in the market.
For example, when you have credit events such as those in California, it may create opportunity. Headlines can cause the yields to go up as the perception of risk spikes. In some instances, those concerns are warranted, but not always.
Ron Mintz: We use our team of analysts and traders to research these issues and determine where there may be mispricing. It is worth noting that we do not have, nor have we had, exposure to muni bonds in the California entities that have sought bankruptcy protection over the past ten years or which are currently going through the process.
When deals come to market, we examine the transaction against our analysis of the region, among a variety of metrics, and we express our opinion on the bond with an internal rating.
Once a bond is in the fund, there is ongoing surveillance of the credit so that there is always an active view on each bond's credit quality.
From a credit perspective, there are always outliers. In a negative credit environment, there are always diamonds in the rough. In a positive credit environment, there are always laggards. In either case, it is our job to find them.
- All investments, including a portfolio's current and future holdings, are subject to risk.
- Investment in bonds are subject to interest rate, credit and inflation risk.
- Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
- Diversification does not ensure a profit or protect against a loss.
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