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Demand has grown over the past year for municipal bonds (munis), which are exempt from U.S. federal income tax and in some cases from state and local taxes. We spoke to Product Manager Bob Fields about the increased investor interest in munis and the outlook for 2007.

 

Q: How has the municipal bond market performed over the past year?

Fields: It has been a remarkable year for municipal bonds. In terms of index performance, the Barclays Capital Aggregate, which is a proxy for the taxable bond market, returned 4.33% in 2006, while the Barclays Capital U.S. Treasury Index returned 3.08%. In comparison, the Barclays Capital Municipal Bond Index, which represents the entire municipal bond market, returned 4.84%. So the muni asset class performed quite well versus most other fixed income sectors.

 

To summarize how muni bonds performed compared to U.S. Treasuries in 2006, intermediate munis rallied nicely while Treasury yields increased. Ten-year, triple-A rated muni yields decreased by about 12 basis points, whereas 10-year Treasury yields increased by about 31 basis points. For longer maturities, 30-year triple-A muni yields decreased by 37 basis points while 30-year Treasury yields increased by 27 basis points.

 

I should add that we are very happy with PIMCO’s municipal bond strategy as well

 

Q: What drove the strong performance in muni bonds?

Fields: What drove the performance of municipal bonds in general was the very strong appetite for tax-free municipal bonds. In addition, if a muni bond portfolio had duration higher than the benchmark last year, it could have benefited even more as muni yields decreased.

 

Q: Where is the strong demand for munis coming from?

Fields: To understand the demand side, let’s talk a little about the types of investors in the muni market. Individuals who pay taxes are the primary investors in the muni market, and last year, they continued to use municipal bonds as their core holdings in fixed income, buying the bonds from brokers or through investment advisors or mutual funds. Property and casualty insurance companies, which make up the second largest buyer of muni bonds, posted big profits in 2006 and invested a significant amount of those profits in the muni bond market. To the extent that natural disasters are limited going forward, we would continue to expect healthy demand for muni bonds from property and casualty insurance companies.

 

In addition, municipal bond hedge funds continued to be supportive of intermediate and longer maturity municipal bonds, which helped to keep yields low. These investors may benefit by borrowing at short-term rates in the muni market and investing in long-term munis.

 

It’s worth noting that demand for inflation-protected municipal bonds was also very strong and resulted in record supply for these bonds in 2006. Although it’s a small component of the market at about $1.7 billion, in the second half of last year, new issue supply added at least $400 million-$500 million to the marketplace. Increasingly, taxpaying investors are realizing that inflation protection should be a component of their asset allocation, and perhaps they are also acknowledging that inflation-protected munis, or what we call muni CPI bonds, are a terrific way to combine inflation protection with the tax benefit of municipals.

 

Q: Was overall supply in the municipal market very high as well?

Fields: New issue supply was very healthy last year at $384 billion. Although that was about 9% below the all-time record of $407 billion in 2005, it was still strong. In fact, the fourth quarter had record supply versus any period we’ve seen in a number of years.

 

Q: Do you expect supply will remain strong in 2007?

Fields: We expect that new issue supply will remain fairly healthy in the coming year, comparable to the 2004 level of about $360 billion. Some very large infrastructure projects, notably from California, should add new issue supply starting in early 2007.

 

Q: You mentioned that municipal bond hedge funds are borrowing at short-term rates and investing in long-term munis. Does that mean that the municipal bond yield curve, unlike the Treasury yield curve, has remained positively sloped?

Fields: We do still have a positively sloped muni bond yield curve. On December 31, the spread between two-year and 30-year triple-A rated muni yields was 54 basis points. At that time, two-year and 30-year Treasuries were yielding the same.

 

However, the muni yield curve was not nearly as positively sloped as it was at the end of 2005 when the spread between two- and 30-year Treasuries was 119 basis points. So over the course of 2006, the muni yield curve did flatten, reflecting the flattening in the Treasury yield curve; but as long as the muni yield curve is positively sloped, hedge funds can lever their investments in long munis by borrowing in the short end, and that trade will continue to be profitable.

 

Regarding the flattening yield curve, yields between weekly floaters and six- or seven-year munis are very flat. It is quite unusual to have any part of the muni yield curve flat and particularly that section of the curve. It is a reflection of what’s going on in the Treasury market, where the curve is inverted.

 

Q: Do you expect the muni bond yield curve to continue to flatten?

Fields: PIMCO expects that sometime in mid- to late ’07, we’ll start to see the Federal Reserve lower the Fed funds rate and ultimately, a positively sloped Treasury yield curve will follow. That steepening should gradually translate into a steeper muni yield curve, too.

 

Q: PIMCO recently introduced the High Yield Municipal Bond strategy. Can you tell us more about it?

Fields: We rolled out the High Yield Municipal Bond strategy on July 31 to meet increased demand from individuals for income products. The portfolio manager, John Cummings, traded high yield munis on Wall Street for more than 20 years. We are fortunate to have such an experienced portfolio manager.

 

What’s unique about our High Yield Muni strategy is, consistent with our approach to high yield bond investing in general, we focus on the higher credit quality end of the high yield muni market. In addition, we reflect PIMCO’s views in our High Yield Muni Bond strategy just as we do in our other strategies. For example, PIMCO has talked about how the weakening housing market will continue to slow the economy. As a result, we are avoiding new project land deals.

 

High yield munis are very project specific. With David Blair as head of municipal credit research, we closely analyze and review each high yield muni project. Is there competition that might impair the ability of a project to pay its debt? How seasoned are the managers of the project? In addition, we like secured deals. If, for example, we buy a bond from a hospital, nursing home, or charter school, we want to make sure we have security. Having collateral, or a first mortgage, is a critical component of our decision-making analysis.

 

Q: Although the High Yield Muni strategy was designed for taxpaying investors looking for income, could other investors benefit from the strategy?

Fields: What’s interesting is we studied returns on high yield munis versus returns on other sectors of the municipal bond market and found that if an investor added a high yield muni component to a core muni portfolio, not only would that combination have had increased return potential but it also would have had lower annualized standard deviation. Our research used the Barclays Capital Muni and High Yield Muni bond indexes to represent the two markets, and we examined data from November 1995, when the Barclays Capital High Yield Muni Index was created, through December 2006.

 

Clearly, the High Yield Muni strategy should be very appealing for a taxpayer who would like added income potential, but even for an investor just looking for total return in the muni bond market, adding a slice of high yield muni bonds to the portfolio may not only add to returns but may also lower return volatility.

 

Q: Stepping away from muni bond performance for a moment, there is an important court case pending before the Supreme Court that may have an impact on the municipal bond market in the future. Can you explain the implications of the case and what you expect?

Fields: In “the Kentucky case,” as it’s called in the market, a group of individual investors have challenged the state of Kentucky for violating the Commerce Clause by taxing out-of-state muni bonds and not taxing in-state muni bonds. The Supreme Court will decide fairly soon whether to take the case. If they do not take the case, then the Kentucky Appeals Court decision that says that the state is infringing on interstate commerce by taxing out-of-state bonds would stand. Kentucky would then have to make a decision whether to no longer tax out-of-state muni bonds or to tax all muni bonds. If the Supreme Court takes the case and upholds the Appeal Court decision, all states would face the same decision.

 

It’s an interesting case. Although it has not yet affected how muni bonds are trading, it’s worth keeping an eye on. It could have implications in particular for “specialty state bonds”—bonds issued within high tax states such as California, New York, Ohio and Massachusetts. Because individuals in those high tax states would no longer benefit by owning in-state bonds, they could purchase bonds from any state or municipality. So it could conceivably turn the municipal market into a more national market as opposed to the regional or state-specific market it is today. On the positive side, a more national market could benefit liquidity. On the negative side, it might mean that bonds from high tax states, which now trade at a premium, could start trading more like other muni bonds.

 

Q: It should be an interesting year for the municipal bond market. Thank you for the update, Bob.