It’s easy to jump to conclusions based on shocking headlines and dire predictions. If that’s all you read, you’d probably be walking around with a stiff neck from looking up, waiting for the sky to fall. Beneath the sensational headlines often lies a more mundane story. This could be the case with the current bout of muni-bond default mania, which harkens back to the muni-market panic in December 2010. Bankruptcy filings in a few California cities could certainly be considered evidence of some of the serious debt problems in the U.S., but they don’t necessarily tell the whole story of the municipal bond market. To fill in the missing pieces, we turned to Franklin Municipal Bond Department Co-Directors Sheila Amoroso and Rafael Costas, and Franklin High Yield Tax-Free Income Fund and Franklin California Tax-Free Income Fund Manager John Wiley, three muni-minded professionals each with 20+ years of experience who aim to put these current developments in perspective. [php function=1]
Their key views in brief:
- Amoroso: It’s impossible to predict how many municipalities could file bankruptcy, but most issuers take their debt obligations very seriously because they require muni market access for funding.
- Amoroso: across the yield curve, munis are currently out-yielding Treasuries, so “munis still look attractive for investors seeking income.”
- Costas: The California bankruptcy filings grab attention, but are “not what we would consider a slew or a spate of bankruptcies.”
- Amoroso: There’s evidence of positive structural budget reform taking place across the country, but it’s a slow process.
- Wiley: from an investment standpoint “it speaks volumes to know what you own, and be diversified.”
Are the recent bankruptcy filings in California (San Bernardino, Mammoth Lakes and Stockton) and predictions that more could be to coming cause for concern? Sure. The question is: how much concern? Amoroso, Costas and Wiley offer their perspective.
Sheila Amoroso: “Right now there are three local governments in California that are in or threatening bankruptcy. Considering there are over 400 municipalities in the state, it’s a very small number. We are not out of the woods yet, but we haven’t seen any major reactions in the market beyond the specific securities of the municipalities mentioned. Each is a unique situation, which makes it impossible to predict how many more could file, but the weaker, smaller governments appear to be the most vulnerable. We have seen evidence of structural budget reform across the country at the local level; it’s just a slow process. The bulk of issuers have made necessary adjustments to bring expenses in line with revenues, and we think they will continue to do so. Most issuers take their obligations to pay very seriously and rely on the municipal market to finance infrastructure spending. A default prevents them from doing so, or results in prohibitively high borrowing costs.”
John Wiley: “There is a great deal of concern about bankruptcy risk, not only In California but nationally, and it’s certainly understandable. Many cities are making the right choices in cutting expenses, but for some, pensions and salaries are growing at a rate that will eclipse their local budgets. There is a clear lack of political leadership at the state and local levels to address growing, underfunded pension liabilities.”
Rafael Costas: “There are some people out there who are saying that if enough of these municipalities start filing (for bankruptcy) then bankruptcy will lose its stigma. We totally disagree with that. You can call it whatever you’d like, but the fact is that these three cities that have filed now have essentially no market access. Access is very important for municipalities to maintain.”
In 2010, when a few analysts warned of waves of municipal defaults, it triggered a mass investor exodus. So far this year, Amoroso and Costas say the market seems to be holding up better despite the bad news. They emphasize that investment-grade municipal bond defaults are rare, and a filing doesn’t always result in a full-fledged bankruptcy. The vast majority of municipalities are paying their debt holders and strive to maintain market access. In Amoroso’s view, the bankruptcies are atypical of the municipal market overall. As she sees it, the panic was unwarranted two years ago, and is unwarranted today.
Sheila Amoroso: “As the catastrophic default predictions did not materialize through mid- to late 2011; we started to see cash flows improve dramatically. In 2012, the supply-demand technicals look favorable for the market, and munis still look attractive to us relative to Treasuries1; across the curve we are seeing munis out-yield Treasuries. In this low-yield environment, we believe munis still look attractive for investors seeking income.”
Looking more broadly at the muni bond market, Amoroso, Costas and Wiley describe what aspects of the market they are particularly focused on, and their investment strategy.
Sheila Amoroso: “Obviously, the weakness in the local government sector is a big focus for us, but also from a market perspective we are scouring the market daily to find value. Considering it’s a seller’s market, it’s a pretty tough environment to get and stay invested. However, we are taking advantage of this environment to sell some of our weaker credits at pretty good premiums.”
Rafael Costas: “They do get a lot of attention (the three bankruptcy filings), but I would say that it is not what we would consider a slew or a spate of bankruptcies. There are some difficult problems at the local level, like revenue flexibility and so on, but at the same time, even though the economy is slow, states are balancing their budgets. There have been some increases in sales taxes, and the real estate market seems to have bottomed out, so property taxes appear to have settled for now. There is some improvement in general credit quality going on too. It’s easy to focus on the negatives issues, but there is some good news out there in many areas of the country.”
John Wiley: “From an investment standpoint it’s so important to know what you own, and be diversified. We are going through every one of our credit-driven securities, even if it’s insured. Because of our experienced research staff of 17 credit analysts focusing on all sectors of the muni bond market (with four analysts dedicated to California alone) we are able to do this, and to find value. The credit market is improving and we feel these pension issues will be addressed. So we believe the market overall could continue to remain attractive for investors.”
It’s times like these when we can’t help but recall one of Sir John Templeton’s more famous quotes: “The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
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What are the Risks?
Franklin High Yield Tax-Free Income Fund and Franklin California Tax-Free Income Fund
For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable. All investments involve risks, including the possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in the funds adjust to a rise in interest rates, the funds’ share price may decline. For the Franklin High Yield Tax-Free Income Fund, in general, an investor is paid a higher yield to assume a greater degree of credit risk. Since the Franklin California Tax-Free Income Fund concentrates its investments in a single state, it is subject to greater risk of adverse economic and regulatory changes in that state than a geographically diversified fund. These and other risks are described in each fund’s prospectus.
These and other risks are described in each fund’s prospectus.
1.It is important to note that Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Fund investment returns and share prices will fluctuate with market conditions, and investors may have a gain or a loss when they sell their shares.