Daniel G. Loughran, senior portfolio manager of the OppenheimerFunds Rochester Investment Team, says that the bond rating agencies "have done a good job over the years rating municipal bonds compared to structured products." He does his own credit analysis. Nevertheless, he feels comfortable enough with the recalibration of ratings to make them comparable to corporate bonds.
Unfunded pension and health-care liabilities are another major investor concern. Liabilities could be more than $1 trillion if post-employment benefits-like health care-are factored.
"We're talking about a significant amount of underfunding and it is definitely a long-term problem for the market," says Hugh McGuirk, head of T. Rowe Price's municipal bond team. "But you have to remember that states are required to balance their budgets annually. Many of these pensions are contractually obligated to meet pension payments. They have to factor that on an annual basis. So many state legislatures have been making a lot of tough decisions. A significant amount of cuts have been made already, but there's still more work to do."
The oversupply of bonds and concerns about bond ratings and pension obligations came to the forefront in November 2010. A market sell-off saw some municipal bond prices drop as much as 4% to 7%. And investors pulled $5 billion out of municipal bond funds the week ended November 17, according to the Investment Company Institute in Washington. The redemptions reflected fears of higher interest rates hitting muni bond prices as well as the changing outlook for high taxes next year with Republicans in control of the U.S. House of Representatives. But since then, money returned to municipals as investors sought high yields.
McGuirk says the decline was due to supply-demand factors, not fear of defaults. Entities are rushing to market with Build America Bonds before the government-sponsored program could terminate at the end of 2010. And in June 2011, more federal aid to states and municipalities might stop under the government's job and stimulus bills.
Currently, investment-grade municipal bonds yield more than 100% of nominal 30-year Treasury bonds. But McGuirk expects bond prices soon will stabilize.
Early this year, T. Rowe Price's Summit Municipal Intermediate Term Fund shortened its duration to about 4.5 years compared with its benchmark's 5.4 years. That reduces the fund's interest rate risk. The fund, however, picked up some yield by taking a position in California general obligation bonds which yield around 8%. Forty-one percent of the fund's portfolio is invested in revenue bonds, which are tied to stable income streams. About 25% is in general obligation and health-care issues.
"The sell-off in the municipal bond market was not driven by defaults or credit-related events, but rather a temporary supply-demand imbalance," McGuirk says. "Municipal issuance has increased in recent weeks as issuers are attempting to take advantage of near-record low rates."
In the meantime, the municipal bond market is under heavy pressure due to issuance oversupply. Demand for municipal securities has weakened in part because absolute yields have reached low levels.
Loughran, of Oppenheimer, says the recalibrated municipal ratings have created buying opportunities. His own analysis has identified a number of underrated issues, particularly in nonprofit college revenue bonds and tobacco bonds. These are cash cow positions that pay attractive yields. He also added some lower credit-rated and non-rated bonds to the Oppenheimer AMT-Free Municipal Bond Fund. The fund's three largest sectors, which represent 45% of the portfolio, are in tobacco master settlement agreement bonds, special assessment bonds and hospital-health care issues.