The municipal bond market has faced substantial challenges over the past few years, from a rocky economy to recent downgrades by one of the major rating agencies. Are better days ahead?
In the following interview, muni investment veterans Joe Deane and Julie Callahan discuss PIMCO’s outlook for the municipal bond market, implications of current events and potential opportunities for investors.
Deane, who has more than four decades of muni bond experience, is the head of PIMCO’s municipal bond portfolio management team. He and Callahan joined PIMCO in July from Western Asset Management Company. Callahan is a portfolio manager with 16 years of investment experience.
Q. Some economic indicators suggest growth may be slowing in the U.S. Do you see risk of a downturn that hits municipalities hard?
A. PIMCO has been describing a global scenario in which developed nations face headwinds to growth, including private-sector deleveraging and greater financial regulation. While the economy may slip more than initially anticipated, we do not believe defaults are a meaningful risk. Many municipalities have been navigating the financial crisis and beyond through aggressive budget cuts, tax increases and “one-time” solutions. As a result, many balance sheets are in reasonably good shape and default rates remain a small fraction of the overall market.
Q. What do you think are the key long-term implications of Standard & Poor’s downgrade of U.S. credit and related downgrade of certain municipal issues?
A. The downgrade of America’s AAA rating to AA+ had a “knock on” effect on municipal bonds that have a direct relationship to the Treasury. S&P has downgraded more than 11,000 muni issues – mostly “pre-refunded” bonds that are repaid by certain Treasury investments, muni housing bonds backed by the federal government and bonds secured by federal leases.
But for the industry overall, the downgrade did not amount to a great deal. In fact, we believe of greater consequence to bond issuers, and to the market, is the outcome of federal budget negotiations. Congress is currently wrestling with how to come up with $2.5 trillion in budget cuts in the midst of a very fitful economic recovery. While some cuts could have no effect whatsoever, reductions to programs such as Medicare and Medicaid would have a significant impact on the flow of funds to states, counties and cities.
Q. Is there a silver lining to recent events?
A. If there is a positive in this environment, it is that it will finally force politicians – both at the state and the federal level – to address issues they have been ducking for far too long. For an extended period of time, politicians enjoyed a kind of demographic and re-election sweet spot. The Baby Boom evolved society into a very large working population supporting a much smaller retirement populace. That made it easy to increase pension and medical benefits, making promises that someone else down the road was going to have to keep.
Well, the first baby boomers are starting retirement this year, which means that the issue needs to be dealt with now. The current economic situation has increased the pressure for federal and state policymakers to come up with sensible solutions.
Also, one of the positives to come out of 2008 is that the muni market is much less leveraged than it was then. At the time, there were a large number of muni hedge funds that were highly leveraged – often 10 to one, or more. That injected a lot of instability into the market, and when it crashed those funds became forced sellers, with enormous losses. Today those types of products are a much smaller presence, with the muni market dominated by cash buyers and sellers. While markets are always going to go up and down, we do not think we are going to see a repeat of that kind of volatility for a long, long time.
Q. What is PIMCO’s approach to managing municipal bonds?
A. We believe long-term investors should take an actively managed, total return approach to muni investment. Indeed, we have long viewed muni investing as about more than trying to earn the best yield, while also seeking tax efficiency (municipal bonds are generally exempt from federal taxation and some are also exempt from state taxation). We focus on yield and total return, adjusting our holdings when we see potentially attractive opportunities.
Further, at PIMCO, we are combining our best ideas with the macro outlook and investment process emanating from the company’s annual and cyclical forums and the Investment Committee. PIMCO is a place where top-down and bottom-up ideas constantly meet, with investors potentially benefiting from the detailed vetting of investment decisions.
Also, while we pursue attractive returns through all market environments, we place a lot of emphasis on downside hedging. Investors certainly want to participate in market upside, but, in our view, avoiding losses may have greater impact over the long term. Our belief is that no matter how strategies may perform in strong markets, if they do a terrible job during down markets, investors lose.
Q. How do you execute your strategies?
A. For us, it always starts with proprietary credit research. This is a key area of strength for PIMCO, which, in addition to our muni team, has more than 40 credit analysts to lend their expertise (as of June 30, 2011). Muni investors had often shrugged off this type of analysis in the years leading up to the financial crisis, preferring to turn to municipal wrap insurance to provide the triple-A ratings they were looking for. We have never relied on bond insurance or outside ratings for our analysis. Today, of course, wrap insurance has disappeared, and investors with the resources and processes in place to do their own fundamental work may have a strong competitive advantage.
In addition to security selection, there are a range of strategies we can access, such as yield curve positioning and the ability to hedge duration risk through interest rate swaps and futures.
Q. Where do you see opportunities for munis today?
A. In this environment, we are currently favoring essential service-revenue bonds. We feel these securities tend to have more consistent revenue streams and lower (or no) pension and medical liabilities than general obligation issues (GO); they are run more like a private-sector credit than a public-sector one. We are also identifying compelling values in spread products – those offering attractive yields relative to higher-rated issues – in industries such as healthcare and gas prepay.
Q. Additional thoughts?
A. Sure. The potential tax advantages of munis – exempt from federal and sometimes state taxes – may appeal to certain investors year after year, and through various market environments. In addition, with the focus in Washington on deficit reduction, it is reasonable to assume that tax hikes could be part of a long-term budget solution, which may increase the appeal of munis. Also, we argue that as baby boomers retire, they may seek more exposure to tax-exempt income – their home mortgages may be paid off, they may draw from retirement accounts that previously sheltered savings or income from taxation, etc. In all, we see significant potential for investor demand for munis to increase in the years ahead.
Thank you, Joe and Julie.