Beyond Bulls & Bears

Moving Past March Muni Madness

After the calendar flipped to 2013, a bit of March madness took hold in the municipal bond market, as a headline frenzy hit and demand turned negative. Rafael Costas, senior vice president and co-director of our municipal bond department, has seen these seasonal ebbs and flows in the market before, and knows when sensational news headlines are more bark than bite. Could March really be the start of a “great rotation” out of fixed income in general? Are some of the headline-makers–including Stockton, Puerto Rico and Detroit–really reflective of the overall muni market? As Costas says, “there’s more hair to the story.”

 When any market has a good run, it’s natural to see a correction, and the muni market is no exception, says Costas.

Rafael Costas

“While somewhat negative, outflows are not a surprise, and I don’t view that as alarming and think it can be managed. We had a series of very good months in 2011 and 2012, and you can’t sustain those great levels all the time. At the end of 2012, there were concerns about the fiscal cliff and what was going to happen to municipal bonds in terms of the [tax] exemption. There’s always end-of-the-year selling, so some may have been cashing out for tax purposes. That’s not a terrible thing…and could turn into a good thing for our investors if rates go up a little on the muni side, in the sense that we can potentially start increasing our dividends. I think investors right now are figuring out what they want to do.”

As the World Turns

Some say this is part of a general investor shift–or “great rotation”—toward equities, which would seem to make sense given equity markets (at least in the U.S.) have moved back to pre-recessionary highs. That said, Costas doesn’t see the death of fixed income for a big reason tied to a big demographic – baby boomers.

“The stock market has started off pretty well this year, and that is likely to draw some assets. Some people are talking about the “great rotation” like everybody is going to leap from bonds and get into stocks. That’s not quite the way we see it. Yes, people are thinking about stocks and want to participate in a rally, but we have to remember that the baby boomers are just starting to retire and they are going to be seeking more and more income. So I don’t think that this “great rotation” is going to be catastrophe for bonds. It can very well be an orderly transition for some investors, while others also tend to come back to fixed income for other reasons. Many investors still recognize the potential benefits of a diversification strategy1, so we don’t expect investors to completely leave bonds”

A Tale of Two Cities: Stockton and Detroit

One of the high-profile victims of the country’s credit crisis was Stockton, California, which filed for bankruptcy protection in June 2012. On April 1, U.S. Bankruptcy Judge Christopher Klein ruled Stockton was indeed eligible for bankruptcy protection, and the city has stated that it will try to force creditors, including bondholders, to take less than the principal they are owed. That certainly wasn’t good news for muni investors, nor were headlines of trouble brewing in Puerto Rico and Detroit’s appointment of an emergency financial manager in March. Costas believes that these situations are isolated cases, not representative of the larger muni market overall. [php function = 1]

“Generally we believe the municipal sector is doing fine. There will be challenges for the next few years as the Federal government tries to solve its problems by pushing them down to the states and as the states push their problems down to the localities and cities. Just about every city seems to have to grapple with the pension issue. But in general, the overall credit picture is slightly improving–certainly not getting any worse. The headlines are just that, they tend to focus on problems as opposed to the 99.5% of the market that’s doing well.

“Stockton is definitely a serious situation, but it’s just one issuer, and relatively speaking, not a very significant one. It does, however, bring to the floor the question about how cities are going to manage their pension problems. Detroit has been on a slow decline pretty much for as long as I have been in the business. So we were and are watching them carefully. It wouldn’t be a big shock to the market, and as mentioned, the problems there have been a long time coming.”

Puerto Rico’s Pension Problems

While Stockton may be small potatoes in the muni market, and the story’s nothing new in Detroit, trouble brewing in the Caribbean could be a bigger concern for the muni market. Puerto Rico, a U.S. territory and large issuer of municipal bonds, has been struggling amid a prolonged recession, resulting in a 15% unemployment rate and a wide structural budget gap. All three major credit ratings agencies recently downgraded Puerto Rico’s bond ratings to just above junk-bond status. Puerto Rico is trying to tackle some of its problems. In early April, new pension reforms to reduce future cash flow deficits into the plan were enacted into law, which ratings agency Fitch dubbed to be “an important step toward achieving credit stability.”

Can Puerto Rico turn things around? Here’s Costas’ take.

“Everybody is watching Puerto Rico because it has been such a big issuer in the municipal market for decades. The economy is still not really growing and there are big pension problems there. But on the somewhat positive side is that Puerto Rico has a new governor with a new legislature of his party coming in this year. They already have passed a law to increase excise taxes, and the pension reform they just passed should bring some breathing room. Nobody is talking about a default scenario, but we are seeing downgrade scenarios and have to be careful it doesn’t become a liquidity problem; many funds would not be able to buy its debt if its rating falls below BBB-, so we are watching it and taking a wait-and-see approach. Fortunately, we’ve been ahead of the curve in anticipating what the rating agencies might do and have been reducing exposure in our portfolios.”

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What Are the Risks?

All investments involve risk, including possible loss of principal.  Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in a portfolio adjust to a rise in interest rates, the portfolio’s value may decline.  Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value.

1. Diversification does not guarantee profit or protect against loss.

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