With Detroit’s recent bankruptcy and Puerto Rico dealing with its own set of challenges, investors are facing a more complex environment in the municipal bond market. In the following Q&A PIMCO’s Joseph Deane, David Hammer and Sean McCarthy discuss how investors can position their portfolios to protect themselves from increasing volatility – and how active duration management can help to capitalize on opportunities.
Q: How do the events in Detroit and Puerto Rico affect your views on municipal credit?
A: Fundamentally, our approach and views have not changed, but we acknowledge that we have entered a less benign period for public finance. The U.S. economy is struggling to achieve escape velocity and although revenues and budgetary deficits are broadly improving, many state and local governments continue to recover and must now contend with rising healthcare costs and increased contributions to their unfunded public pension plans.
Despite historically low default rates for municipals relative to investment grade corporates, distressed municipal issuers are periodically compelled to restructure their obligations out of necessity. The inability of states and territories to avail themselves of Chapter 9 bankruptcy only increases the risk of a more disorderly outcome, since they can still default on payments, triggering a need to restructure. Recoveries may be lower than the historical experience, as initial indications in Detroit suggest.
We do not anticipate a significant increase in the frequency of municipal defaults, but there are pockets of credit stress in U.S. municipalities and territories, particularly those with unfunded pension obligations and budgetary imbalances that may be unsustainable given regional economic growth outlooks.
In those instances, the issuer’s willingness to pay may simply fall short of capacity, and restructuring may be a rational economic consideration. Investors should consider the possibility of this outcome when making investment decisions and ascertain whether they are being adequately compensated for these risks.
Q: How should investors position their portfolios in light of Puerto Rico and Detroit credit stress?
A: Large concentrations of exposure to Puerto Rico within subsets of the municipal market will likely lead to an increase in spread volatility across other municipal sectors in the coming quarters. Avoiding credits with large and growing fixed costs, such as unfunded pensions, and issuers that rely heavily on capital market access to fund operating deficits is only half the battle. Investors should continue to favor high quality and liquid investments that are more likely to outperform through periods of increased spread volatility.
It is also important to keep in mind that contemplated changes in monetary policy through a Federal Reserve tapering of asset purchases and bouts of higher interest rate volatility have had significant effects on municipal bond performance in recent months. Less liquid and riskier credits underperformed during this period. If these macro conditions persist, non-investment-grade municipals will struggle.
Q: How do you think about duration during periods of volatility and credit stress?
A: During periods of increased municipal market stress and spread volatility the municipal curve tends to steepen more than swap or Treasury curves do. From June to July, the AAA muni yield curve steepened by more than 30 basis points between 10 and 30 years, while the Treasury curve flattened. This was similar to past cycles.
Active duration management is key to capitalizing on these moves. Given the high likelihood of further idiosyncratic steepening events over the cyclical horizon, investors should position their portfolios defensively and with reduced duration when option-adjusted spreads are relatively tight, particularly as PIMCO remains less constructive on the long end of the U.S. rates curve.
Q: What kind of opportunities does spread and curve volatility create for investors?
A: Assuming portfolios are positioned defensively when entering these periods of higher volatility, the market offers many attractive opportunities to deliver alpha through selective duration extension once technicals begin to show signs of improvement. For example, in June and July investors could purchase tax-exempt AA rated transportation revenue-backed bonds with 30-year maturities at yields equal to similarly rated taxable risk. In normal times AA rated tax-exempt debt trades at 85%–90% of comparably rated taxable debt, and in fact we have already experienced a great deal of mean reversion and spread tightening over the last month.
We also saw opportunities to capitalize on oversold liquid tax-exempt high yield bonds. However, in light of expected future market conditions we will likely tend to avoid adding this type of risk unless it is very cheap and liquid, and would likely take tactical positions that we would hold for shorter periods, selling them into market strength. Increasingly volatile markets present excellent opportunities to create value, but only if investors are able to be nimble. We believe active total-return-focused investors, as opposed to more passive buy-and-hold strategies, will be rewarded. Portfolios need to be repositioned quickly, which again means emphasizing liquid holdings.