Joe Deane, head of municipal bond portfolio management at PIMCO, discusses recent muni market events, including Puerto Rico’s restructuring bill, their
implications, and where he’s putting money to work in the market today.
Q: Municipal bonds have outperformed in recent months. Is now a good time to invest in the market? Are municipal bonds still attractive?
We’re seeing a stronger demand for federal tax-free income due to higher federal income tax rates coupled with improving perceptions of credit risk in
the municipal market. When considering their relatively attractive tax-equivalent yields, we believe munis continue to provide value.
Year-to-date, municipal mutual funds received nearly $5.5 billion in inflows, including over $5.2 billion into high yield municipal mutual funds.1 This strong demand coupled with low primary market supply has led to positive municipal performance generally and outperformance in the high yield
municipal space, specifically, versus the broad muni market. In our view, the recent rally in the high yield segment of the muni market and the
corresponding tightening of credit spreads signals a degree of risk complacency in the market. An increase in new issue supply, secondary selling, or a
negative credit event could normalize credit spreads and weaken the high yield segment of the market – for these reasons, we believe caution is
warranted. Some of this weakness was evidenced in late June, following the Puerto Rico restructuring bill and the resulting selling pressures in some
segments of the high-yield market. We have not yet, however, seen more widespread credit spread widening.
Additionally, we may see some increased refinancing activity through the summer months, but we believe new issue volume is likely to remain muted
through the rest of 2014. Still, investors should keep an eye on supply pressures, particularly when the municipal market is trading rich, or when
yields are low relative to Treasuries or corporates. In those periods, a sizable increase in new issue supply could put downward pressure on prices and
create improved pockets of opportunity. Part of the job of active managers, like PIMCO, is to anticipate the supply pressures that may arise and take
advantage of these situations by adding positions in attractively priced securities.
Q: Puerto Rico continues to make headlines. Can you discuss recent events and our view on the commonwealth?
Puerto Rico is the third largest debt issuer in the U.S. – after California and New York – and we just don’t think that’s sustainable. In fact, we
currently have no exposure to Puerto Rico in our tax-dedicated national and state-specific strategies, but that wasn’t a Johnny-come-lately decision.
We began to unwind our positions about two years ago when our team of analysts uncovered a number of economic challenges, including weak growth and
massively underfunded pension liabilities, which we believed pointed to ongoing economic difficulties for the commonwealth.
In April, Puerto Rico’s tax revenues fell well below its estimates, largely due to weaker than expected corporate income tax receipts, and its economy
is still sluggish. Additionally, its unemployment rate remains high at 13.8% and labor force participation rate is extremely low. When we combine that
with its recurring budget deficits since the early 2000s and negative population growth, which has declined ~5.6% over the past ten years, we
anticipate continuing difficulties going forward.
The recent passage of legislation in Puerto Rico, which allows some ailing public corporations, including the island's power, water, and transportation
authorities to restructure their debt, seems to affirm our long-term view that restructuring was being considered on the island, and may be necessary.
The bill carves out GO debt, the Puerto Rico Tax Financing Corporation (COFINA), pensions, and the Government Development Bank (GDB), meaning these
issuers are not eligible for restructuring under this regime. However, we wouldn’t rule out a renegotiation of additional claims in the future that
could potentially affect issuers ring-fenced by the current bill. After the bill passed, many of the island’s issuers, including the GO and COFINAs,
were downgraded by Moody’s because, in their view, the bill “has implications for all of Puerto Rico’s debt.” Fitch and S&P followed suit and
downgraded a number of the island’s issuers as well.
The market seems to be pricing in Puerto Rico’s weakened financial state and risk of restructuring as the entire the island’s complex came under strong
pressure with broad-based selling. We believe these liquidity pressures will not only put pressure on Puerto Rico’s debt pricing but may also put
pressure on other segments of the municipal market such as higher quality assets that are sold to meet redemptions. Importantly, this could create more
attractive pockets of opportunity in the current market.
Q: Many state-specific mutual bond funds have begun to see modest outflows, according to Morningstar data – what’s the reasoning behind this shift
following many years of inflows?
In addition to being free from federal income taxes, the income provided by state-specific muni bonds funds may also be free from state, and in some
cases, local income taxes for residents of those jurisdictions. This has typically been very compelling for investors who live in states with high
relative income taxes like New York and California. Funds in these states have, in fact, continued to experience inflows over the course of the year,
likely due to the attractiveness of the tax-exemption with the particularly high tax rates. For investors, whose federal tax bracket increased from 35%
to 39.6% in 2013, a 3% yielding municipal bond will provide a tax equivalent yield of 4.97%. If you live in a state like California, your state taxes
went from 9.25% to 11% in 2013. For these investors, a 3% California municipal bond would equate to a taxable equivalent yield of 6.07%.2
That said, some state-specific funds have greater concentration risk due to limited diversification in those states that have lower overall new
issuance on an annual basis. The recent outflows may be attributed to some of the exposure to territory paper, such as Guam, the Virgin Islands and
Puerto Rico, which often comprise a large percentage of state-specific funds due to the triple tax nature of the territories.
It’s important to note that in both state-specific and national portfolios, the primary emphasis on security selection must be placed on
creditworthiness and ongoing credit analysis. Our team of five dedicated municipal bond analysts taps into the expertise of more than 40 firmwide
credit analysts to help us to actively manage the credit risk of every security we purchase for our state-specific and national portfolios.
Q: PIMCO’s outlook for the U.S. housing market is positive and yet we continue to remain underweight GO debt, particularly local and school district
GOs. What’s driving this positioning?
While we believe the probability for municipal defaults overall, is still relatively low, there has been an increase in local and school district GO
credit downgrades in recent years. This is due, in large part, to the underfunding of their public pensions and other post-employee benefits (OPEB)
liabilities, which is threatening the creditworthiness of these state and local governments. These underfunded liabilities have become a major issue
for many state and local governments and will likely continue to put pressure on credit quality in the future – especially when you consider that the
first wave baby boomers are just starting to retire. This credit metric is increasingly important as the security strength of General Obligation (GO)
pledges remains uncertain as we have witnessed more instances of Chapter 9 filings that put GO bondholders on equal footing with, or even subordinate
Recently, the Government Accounting Standards Board (GASB) proposed new guidelines that would require, among other things, that state and local
governments recognize the OPEB liabilities on their balance sheets. The guidelines would provide greater transparency into these underfunded
liabilities, which could potentially result in select rating agency downgrades and underscores the need for active credit oversight.
Pension and OPEB liabilities are a critical metric in our credit review process. Our municipal credit research team carefully examines an issuer’s
entire capital structure, including obligations from tax-supported debt and pension and healthcare plans. Because we take a forward-looking approach,
our analysts make regular adjustments to our debt metrics to capture an issuer’s historical contribution pattern to their retiree obligations as well
as any reform measures, helping us to forecast the growth of future liabilities and gauge the direction of credit ratings.
Q: When putting money to work in the municipal market today, where are you focusing?
Because we believe that uncertainty with regard to interest rates and/or negative credit events could cause periods of volatility in the muni market,
we remain defensively positioned. Broadly, we favor higher quality securities with an emphasis on liquidity, and look to rigorous credit analysis to
uncover securities with attractive valuations and the potential for superior risk-adjusted returns.
We continue to favor revenue-backed bonds over GO debt, but we are also identifying attractive GO bonds in geographies that have benefited from the
continuing U.S. housing recovery, have positive wealth trends, low structural and cyclical unemployment, well-funded pension systems and are less
vulnerable to union conflicts.
We’re concentrating our duration positioning at, or below, the benchmark due to the potential for interest rate and spread volatility in the upcoming
months. And to enhance return potential, we’re optimizing yield curve placement by targeting intermediate maturities of 5-20 years, which we believe
offer the best potential for price appreciation, given that the curve flattens meaningfully on the longer end.