For many people, putting the description "boring" in front of "municipal bonds" is repetitive. But disagreeing is one of the country's most influential fixed-income managers, who is enthusiastic about a municipal bond market that she says is more exciting than any she has seen in her 23-year career.
"This market is more than interesting. It's unprecedented," says 49-year-old Christine Thompson, who oversees six tax-exempt funds and $20 billion in assets for Fidelity. "Values relative to other asset classes are at levels we have never seen. It's a great opportunity to enter the municipal market and to benefit from attractive relative returns as market conditions stabilize."
Across the maturity spectrum, municipal bond yields are equaling, and often exceeding, the yields on taxable securities. Driven by credit problems and technical pressures, two-year triple-A municipal securities yields stood at an unheard of 180% of comparable Treasury securities in early March. Longer-term bonds with maturities in the 20- to 30-year range, which rarely match the yields of comparable Treasuries, were yielding 20% more. Among Fidelity's stable of funds, the recent 5.98% taxable equivalent yield of Fidelity Municipal Income Fund for someone in the highest federal tax bracket beat the 4.87% taxable yield of the Fidelity Investment Grade Bond Fund and the 5.78% yield of the Fidelity Strategic Income Fund, which contains a significant below-investment-grade and emerging-market component.
High relative yields aside, a series of hedge fund and bond insurer-related issues are still clouding the market, and municipal indexes have lagged most taxable bond indexes by a considerable margin over the last year. But with so much value out there, Thompson believes that underperformance relative to taxable securities should reverse, and that tax-exempt securities "are poised to outperform taxable fixed-income by a wide margin" over the next year.
What has driven muni prices down, and their yields up, is a confluence of events behind a flood of selling and a crisis of confidence among investors. Late last year and early this year, hedge funds such as 1861 Capital Management, Duration Capital Management, Blue River Asset Management and others began selling their municipal holdings as munis cheapened in comparison with Treasuries and their hedges unraveled. Although retail investors historically have favored municipal bonds, hedge funds and foreign investors have become more active participants in recent years.
As the hedge funds flooded the market, bond-rating agencies put several bond insurers with excessive subprime mortgage exposure on credit "watch lists," a harbinger that their triple-A ratings-the same treasured rating status conferred on the bonds they insure-are teetering dangerously close to a downgrade. Because these insurers have backed about half of all bonds sold in recent years, the impact reverberated in virtually every corner of the muni market. As investors began trading the bonds based on their underlying credit ratings rather than their insurance carrier's financial strength, prices on many insured bonds fell in value and yields rose.
Although Thompson believes municipals have been driven down to very attractive valuations relative to taxables, her short-term outlook remains guarded. "You can't say the problems with the bond insurers are over unless you can predict what the housing market will do. The initial shock is over, but several insurers remain on negative credit watch. Technical pressures will work out, but it may take some time. The problems in the market have not yet been played out."
The strength of state and local governments also comes into focus as states such as California struggle with the uncertainty of falling housing prices and growing budget deficits. According to the Center on Budget & Policy Priorities, 50% of states are facing budget deficits and revenue shortfalls. Although defaults on general obligation bonds are extremely rare, a credit downgrade could affect the value of bonds backed by softening tax revenues. In light of economic uncertainty Thompson is drawn to water and sewer bonds, whose debt is paid from private receipts for an essential service rather than more cyclical tax revenues. Higher education bonds also get the nod because of demographic trends that point to increasing enrollments, as do bonds of states such as Illinois and Texas that have no or low state income taxes. The latter bonds generally offer better values than bonds from states where high state income taxes lead to strong in-state demand and higher valuations for bonds issued there.
As technical and credit factors continue to permeate the market, the economic environment remains vulnerable. "We are in a cascading credit contraction that may be difficult to remedy and I am concerned about the financial industry's ability to deal with credit issues, and the Fed only controls one key interest rate so there are limits on what it can do," she says.
Thompson believes that although many financial advisors buy individual bonds, today's complex market makes a low-cost mutual fund a better alternative for most of them. "A bond is a contract with about 500 pages of documentation behind it. Even if it is insured, recent events illustrate that you need to know something about the underlying issuer, and most people do not have the time nor expertise to really evaluate all that."
For 44 basis points a year-significantly less than the 109 basis points charged by the average municipal bond fund-shareholders get a relative bargain and broad market exposure in the Fidelity Municipal Income Fund. "Such low expenses are what we'd expect in an index fund, but investors buying in here actually get access to an actively managed portfolio from one of the best muni teams in the business," notes Morningstar analyst Andrew Gunter in a recent report. "All things considered ... especially the depth of its investment team and its low expenses-we think this fund's future is as bright as its past."
That past includes a difficult 2007, when the fund posted a 3.13% return, compared to 1.15% for the Lipper General Municipal Debt Fund average. A key factor in boosting relative performance was to underweight discount bonds in favor of overweighting intermediate-maturity premium bonds trading above par value. Premium bonds significantly outpaced discount bonds because as bond yields rose, many discounts fell in value as they approached or reached price levels where they became subject to unfavorable tax treatment. Bonds priced above par also benefited because their intermediate maturities made them sensitive to interest rates, which fell during the final months of the year.
While Thompson keeps the fund's duration in line with the Lehman Brothers index to avoid making interest rate bets, she will make adjustments to credit composition or bond structures. A decision to modestly overweight lower-quality investment-grade municipals relative to the fund's benchmark, the Lehman Brother 3 Plus Year Municipal Bond Index, worked for much of the year. But it proved less attractive in the second half as questions about the soundness of municipal bond insurers prodded investors into higher-quality alternatives.
Widening yield spreads between the highest-rated municipals and those somewhat lower on the credit rating ladder are prompting her to look for bargains in bonds of issuers a bit further down the ratings scale. From 2003 to August 2007 risk premiums were fairly tight and investors were not being paid to invest in less than stellar issuers, she says. But since August risk premiums have expanded aggressively as risk-wary investors flock to safety. "A year ago a triple-B hospital bond was trading at a tight spread of just 40 basis points off of a triple-A rated bond. Now, the spread is about 140 basis points. That's a pretty aggressive risk premium expansion in such a short period of time."
At the end of January, the fund had about 68% of assets in triple-A rated securities. Thompson anticipates reducing that exposure over the next couple years as buying opportunities arise to shift some of the money into higher-yielding mid- and lower-tier credits.
She continues to favor bonds selling at a premium over par value, particularly those that are likely candidates for an advance refunding. In an advance refunding, the issuer sells new bonds prior to the first call date in order to repay more expensive outstanding bonds with higher coupons. The proceeds of the new issue are typically invested in government securities placed in escrow. Once an issuer announces an advance refunding, the price of the outstanding bonds will typically jump to reflect the shortened life of the now-secured debt. Thompson says it is not unusual for a bond to gain 5% or more in value on the set up of an escrow account. At times, she will also buy bonds at a slight discount to par value, but avoids those with deeper discounts because of potentially unfavorable tax consequences.
Insured municipal bonds tarnished by insurer credit rating issues are also on her radar screen. Default rates on municipal bonds are very low, so in many cases the insurance is more window dressing for retail investors than anything else. "Insured bonds represent some of the better values around today because even the ones with solid credits behind them have been punished by the market. The key is doing a thorough analysis of each issuer and each bond," she says.
