If investors earn their coupons on municipal bonds this year, they will be lucky. Much depends on the long-awaited economic rebound.
An improving economy should help bail out most states, currently running budget deficits. States are tapping reserves to make it through 2002. But 2003 also could be a bad year if Fed rate cuts are slow to revive economic activity and a government tax-stimulus package fails to materialize.
"There is a budget crisis," says Robin Prunty, director of public finance with Standard & Poor's. "They (states) are facing shortfalls relative to the size of their budgets."
Prunty says Standard & Poor's hasn't downgraded many credits this year. The average state bond carries an AA rating. But some states are in hot water because they have exhausted their reserves. The ratings agency put bonds issued by Tennessee, Hawaii, Wisconsin and Colorado on credit watch. Indiana, Kentucky and Massachusetts have negative ratings outlooks.
Most states, she says, have taken steps to limit the damage. They have cut budgets, foregone tax cuts and are routing part of their reserves toward budget deficits. Take New York, for example. Expecting a $5.7 billion shortfall in 2003, the state has cut its budget, downsized its staff by 5,000 and dipped into reserves.
Florida, which had a $1.3 billion budget gap in the current fiscal year, has left reserves intact. The state slashed its budget, delayed a tax cut, broadened its state sales tax and cut its deficit by using funds outside of the budget.
It's unlikely any states will cut taxes this year. And tax increases could be looming.
"We expect to see few-if any-significant tax cuts enacted in 2002," says analyst Nicholas Jenny in a recent report by the Rockefeller Institute in Albany, N.Y. But if the economy doesn't improve, Jenny says, states will increase taxes and tap more budget reserves and tobacco-settlement funds.
Moody's view is that the recession will end in 2002. Nevertheless, John Puchalla, Moody's senior economist, is cautious. If a meaningful economic recovery takes longer than expected, housing markets will begin to slip. And the outlook for local governments will turn negative. Prunty is concerned we may not have a uniform economic recovery, and some states or regions still may have deficits next year.
Despite the sobering state government budget news, money managers say the municipal-bond market is in better shape than during the recession of 1990 and 1991. Municipal-bond funds gained almost 6% last year. The funds were up another 1.5% at the end of January. In addition, high-grade municipal bonds are yielding as much as comparable taxable Treasury securities.
Mike Roberge, director of municipal research at MFS in Boston, believes the municipal-bond market will hold up well this year. States are in the red, he says, but the economy is on the rebound. "There is no question state-government credit quality has weakened," Roberge says. "We have a slowdown in tax collections. We do expect some credit deterioration. But states are in better shape than in the last recession. They have tobacco funds they can use. They have more rainy-day funds and have managed the surpluses better than in the last recession."
Meanwhile, Mary Miller, assistant managing director of the fixed-income division at T. Rowe Price, says the slowing economy and lower interest rates are helping high-quality municipal bonds. But high-yield tax-free bonds are under pressure.
The two money managers expect municipal bonds to earn their coupons over the next year, but you won't see stellar returns.
What if a long business downturn lasts well into this year? That is not in the cards due to lower interest rates and inflation, believes Roberge, who also manages the MFS High-Income Fund. "The economy hit bottom the end of last year," he says. "Inflation will not be a problem."
Although Roberge is optimistic, he says the MFS Municipal Bond Fund, which yields 5%, is playing it safe. He is avoiding California and New York issues because they are not good buys relative to other tax-free bonds. California has a big deficit, and energy is still a severe problem. Meanwhile, it could take some time for New York to recover economically from the September 11 terrorist attacks. New York state and city have large deficits. The effects of budget cutting and a strong economy could take several years to materialize.
Miller, who manages T. Rowe Price's California Tax-Free Fund, is very cautious about California. She has lowered her exposure to the state's general-obligation bonds. California has had to use much of its own money to fund power purchases and is expected to pay for it with a bond issue this fall. Plus, the economy is off because of the downturn in the technology industry. So Miller is focusing on California water and sewer, health-care and local government bonds because there is less credit risk.
For the most part, budget deficits are causing fund managers to choose revenue bonds over state general-obligation bonds.
Roberge says the MFS Municipal Bond Fund is buying only revenue bonds and insured bonds. The MFS Municipal High-Income Fund is sticking with bonds tied to revenue in the hospital, nursing-home and multifamily-home sectors.
Miller, who also manages the T. Rowe Price Tax-Free Income Fund, used the recent pullback in bond prices after the terrorist attacks to buy higher-yielding sewer, ground-transportation and hospital-revenue bonds. Housing bonds are one area of strength, Miller says. She does not expect to see property-tax revenue fall. She also favors revenue bonds of central services, such as water, sewer and toll roads. The bonds typically pay higher yields and are less cyclical.
Meanwhile, David Dowden, manager of the Alliance Muni Income National Fund, does not have one penny invested in state general-obligation bonds. More than 20% of his portfolio is in the following types of revenue bonds: community-facility issues, which pay for the development of roads and sewers in housing developments; single-family mortgage bonds, which raise funds to help first-time homebuyers purchase property; and state bonds secured by tobacco-settlement payments.
"There is a decline in tax receipts," Dowden says. "The impact isn't being felt in our portfolio. We prefer to invest in undervalued revenue-bond issues."
Some fund managers are more optimistic about New York's bonds, despite the huge projected deficit. Cliff Gladson, manager of the USAA New York Tax Exempt Fund, says New York state and city bonds are bouncing back. "There have been near-term dislocations, and revenue has been off in New York City," Gladson says. "They (New York) built up reserves long before the federal government's help. The rebuilding and reconstruction may lead the way to economic recovery for the entire nation."
Gladson is convinced the outlook for New York munis is favorable. Demand is good, and supply is limited. The fund, which yields more than 4%, owns 40 investment-grade-rated credits. He is avoiding industrial-revenue bonds because they are subject to the alternative minimum tax. The fund holds about an equal amount of general-obligation and revenue bonds. He favors issues secured by strong reserves. New York City Municipal Water, which makes up 8% of the portfolio, is his largest holding. He also owns mental-health, mortgage-agency and development bonds.
Gladson recently purchased Columbia University bonds, which are rated AAA. The university has a large endowment and a strong balance sheet.
High-yield municipal bonds had their problems last year. Concerns about a recession pushed bond prices lower. But Mark Otterstrom, manager of the Waddell & Reed High-Yield Municipal Fund, navigated his fund to a 5.3% annual return in 2001. "I've been shifting to more liquid BBB credits until the economy gets stronger," he says.
His largest concentration of credits is in health care, a traditionally recession-resistant area. Seventeen percent of the fund's assets are invested in nonprofit life-care centers throughout the United States. Life-care centers offer independent assisted living and nursing care for seniors. He also has 5% in cash. As a result, the fund yields 5.2%.
Otterstrom says life-care center bonds can be very profitable. He buys the bonds during the preconstruction phase, when they are noninvestment-grade securities paying as much as 8%. When a life-care facility fills to capacity, the bonds are refinanced, and the credits become investment grade.
The biggest risks: Seniors are reluctant to sell their homes and move to a center if the real estate market is poor.
The greatest danger in the muni-bond market could be that the economy may bounce back too quickly and bond prices plunge if rates jump back up. "Two-thirds of the market are rated AAA, and many of these bonds carry insurance," says Miller, who also manages the T. Rowe Price California Tax Free Fund. "Rising interest rates are more of a risk."