Evolving municipal bond market makes compelling case for active management

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1 February 2012» Putnam Perspective Evolving municipal bond market makes compelling case for active management Thalia Meehan, CFA Portfolio Manager Paul M. Drury, CFA Portfolio Manager Susan A. McCormack, CFA Portfolio Manager Key takeaways Municipal bonds remain strategically important investments with significant tax advantages and generally low correlations to other asset classes over time. The near elimination of bond insurance has dramatically changed the municipal ratings landscape. Municipal bond fundamentals are helped today by low defaults and attractive spreads over Treasuries. The classic strategic reasons to own municipal bonds still hold true: They generally have low correlations to other asset classes and offer a meaningful tax advantage to investors features that are unlikely to change in the near term. However, the municipal bond market has experienced a significant shift over the past several years through the virtual demise of municipal bond insurance and the stress of highly constrained federal and state budgets. This paper will examine how these changes in the municipal bond market have had an impact on the evaluation of municipal securities, whether it makes sense to invest in municipal bonds today, and how investors might need to change the way they implement their investment strategies as a result. Figure 1. Municipal bonds are not highly correlated with other asset classes Municipal bond correlations versus other assets (1/31/92 12/31/11) 1- to 3-month T-bills 0.03 S&P 500 Index 0.09 Actively managed funds driven by fundamental research can help add broad diversification and mitigate risk. U.S. high-yield bonds 10-year U.S. Treasuries AA U.S. corporate bonds Sources: Barclays Capital Bond indices, Standard & Poor s. Stacking up yesterday versus today In comparing the municipal bond market from 10 years ago with today s market, many characteristics remain consistent. A decade ago, the top five state issuers were California, Florida, Illinois, New York, and Texas and represented roughly 50% of the market; this is still true today. In fact, nine of the top ten issuers from 2001 were still on that list in 2011, and continued to constitute approximately 65% of the market. Among the changes has been a general trend away from local general obligation issuance toward issues backed by special taxes or assessments. In many instances, the issuance of general obligation debt requires voter approval. One way to avoid going through that process is to issue special tax/assessment debt, which may require no PUTNAM INVESTMENTS putnam.com

2 Figure 2. The top nine issuing states and Puerto Rico have remained consistent By market value ($M) 200,000 12/31/01 12/31/11 150, ,000 50,000 0 California New York Texas Florida Illinois Massachusetts New Jersey Puerto Rico Pennsylvania Washington Source: Barclays Capital Municipal Bond Index. vote or a vote by a more limited group of taxpayers. This shift could also be considered an indication of investor preference for clean flows that other governmental entities are not allowed to access, as well as generally reliable covenants supported by rule of law. Figure 3. An increase in issues backed by special taxes/assessments reflects a tougher budgetary environment Distribution of municipal sectors Sector distribution (%) 12/31/01 12/31/11 Change State general obligation Transportation Local general obligation Special tax Water & sewer Hospital Leasing Education Power Other (< 3%) Source: Barclays Capital Municipal Bond Index. However, the key shift in the market has been the considerable change in credit quality distribution. As of December 31, 2001, the AAA segment of the municipal bond market represented approximately 60% of the market; that figure has declined to only 13% today (Figure 4)! 1 This major change can be attributed to two factors: most important, the near elimination of bond insurance for the municipal market, but also the downward migration of municipal ratings in the wake of significant fiscal stress at both the federal and state levels. At its peak over the past 10 years, bond insurance was used in 57% of municipal securities issued in 2005, with the bulk of the underlying securities carrying insurance rated single A. (As seen in the 2001 credit quality chart of Figure 4, if bond insurance had been stripped out, the municipal bond universe would have had a significantly higher concentration of A-rated securities, rather than a AAA-rated segment representing more than 50% of the market.) In 2011, usage of bond insurance declined to a mere 5% (Figure 5). This precipitous drop in bond insurance began in 2008 as the insurers experienced mounting losses associated with guarantees on subprime mortgagebacked debt. As a result, insurers were downgraded and lost their top ratings or entered bankruptcy. Without the ability to achieve a top rating and therefore lower their debt costs, most municipal bond issuers lost the incentive to pay for the additional credit enhancement. The decline of insurance is only one of the factors contributing to the downward trend in credit quality. Moody s Investors Service reported the downgradeto-upgrade ratio for the third quarter of 2011 at approximately 5.3 to 1. This is the highest ratio since the 1 Barclays Capital, Barclays Capital Municipal Bond Index. PUTNAM INVESTMENTS putnam.com 2

3 Figure 4. The decline of bond insurance has sharply reduced the availability of AAA bonds Credit quality composition 12/31/01 12/31/11 AAA AA A BBB Source: Barclays Capital Municipal Bond Index. beginning of the financial crisis in 2008; however, the absolute number of downgrades in the third quarter (163) was less than the peak experienced in the fourth quarter of 2010 (197). While downgrades may be high by historical standards, keep in mind that they represent a small portion of the Moody s-rated public finance universe in the third quarter: less than 1% (Figure 6). 2 2 Moody s Investors Service, U.S. Public Finance: Third Quarter Sets New Peak for Ratio of Downgrades to Upgrades, November 1, Value to be found Given these structural changes, investors may be wondering whether municipal bonds continue to warrant an allocation. We believe municipal bond investments are potentially quite attractive: Defaults have remained low, contrary to overblown predictions in the media; spreads are attractive on a historical basis; and muni/treasury ratios are still above historical averages. Defaults in the municipal bond market are generally misunderstood. While defaults do happen, they occur with far less frequency than in the corporate bond Figure 5. Bond insurance as a percentage of total municipal new issuance 60% Source: The Bond Buyer, PUTNAM INVESTMENTS putnam.com 3

4 Figure 6. Despite the recent uptick, defaults are low as a percentage of the total market Municipal defaults since % Sources: Distressed Debt Securities Newsletter, Putnam, as of 11/21/11. Municipal market is estimated at $3.7 trillion. market, and more often than not, they are confined to particular sectors of the market, typically in land development deals or unrated securities. We believe bond insurance had very little impact on historical default statistics; the insurers generally provided credit enhancement for single-a deals and not for those at the low end of the rating spectrum, which are more prone to default. When defaults occur, they tend to capture headlines. Recently, American Airlines s $3.2 billion in municipal debt as well as approximately $15 billion in tobacco settlementbacked debt were added to default statistics although no payments have been missed; these defaults were due to the particulars of the calculation methodology that has been used for many years by the Distressed Debt Securities Newsletter. The methodology includes technical defaults as well as bankruptcies and other forms of non-monetary default, e.g., accessing reserve funds, as is being done in the case of the tobacco bonds. Jefferson County, Alabama another headline-grabbing default in 2011 had been in negotiations for several years trying to work through its fiscal issues; however, the county recently opted to file for bankruptcy and became the largest municipal bankruptcy in U.S. history at $4 billion. The county s general obligation debt of about $1 billion was also recently added to the default statistics. While municipal defaults have ticked up recently, it is important to note that the predicted massive number of defaults has not materialized. Nearly one year ago, one well-known analyst predicted 50 to 100 sizeable defaults, totaling hundreds of billions of dollars. Those fears are proving to be unfounded. In fact, muni defaults are only minimally higher than their 20-year peak in 1991 and are outpaced historically at every rating level by corporate bond defaults (Figure 7). 3 This is not to say that there will not be future defaults in the municipal market; there will be. But the fundamental budget stress at the heart of the current struggles will slowly ease as the fiscal measures being put into action by the states and municipalities begin to take effect and as the U.S. economy continues to improve. 3 Moody s Investors Service, U.S. Municipal Bond Defaults and Recoveries, , February Muni defaults are only minimally higher than their 20-year peak in 1991 and are outpaced historically at every rating level by corporate bond defaults. PUTNAM INVESTMENTS putnam.com 4

5 With spreads wider than historical levels and defaults remaining low, the investor is getting paid more than average for risks that are generally in line with historical norms. Figure 7. At every credit rating, corporate defaults outpace those in the muni market Moody s 5-year average cumulative default rates Rating Municipal Corporate All rated 0.05% 7.14% Aa A Baa Ba B Investment grade Speculative grade Source: Moody s Investors Service, U.S. Municipal Bond Defaults and Recoveries, , February It is worth noting that recoveries in the municipal market also run higher than is typical in the corporate credit market, though the range is quite wide. For the Moody srated defaults occurring from 1970 to 2009, the average recovery rate was approximately 67%, while the range was anywhere from below 5% to 100%. 4 For example, the 1994 Orange County, California bankruptcy was the largest municipal bankruptcy in history at that time, but what few investors recall is that all principal and interest payments were made. Compare this with the average corporate recovery rate of 41% from 1982 to That is roughly a 25% difference; recovering a quarter more in value is quite meaningful. 4 Moody s Investors Service, U.S. Municipal Bond Defaults and Recoveries, , February Moody s Investors Service, Corporate Default and Recovery Rates, , February With that backdrop in mind, spreads on credit tiers below AAA look attractive compared with their historical averages. The presence of bond insurance primarily influenced the AAA credit sector, so focusing on AA and below is a better measure of historical spread levels. Current spreads range from 20 basis points to over 100 basis points for securities rated AA to BBB versus their historical averages over the past 13 years (Figure 8). 6 If the volatile time period of October 2008 through December 2011 is excluded, the comparison of current spreads to a normalized time period (January 30, 1998, to September 30, 2008) illustrates that today s spreads are 50 (AA) to 150 (BBB) basis points wider than would typically be expected. With spreads wider than historical levels and defaults remaining low, the investor is getting paid more than average for risks that are generally in line with historical norms. Another measure of the attractiveness of municipal securities is the comparison with U.S. Treasury securities, generally referred to as the muni/treasury ratio. Typically, the AAA-rated municipal yield is compared with the yield of a similar duration U.S. Treasury security. Current muni/treasury ratios for 5-, 10-, and 30-year maturities are at levels approximately one standard deviation away from their long-term averages. In part, this is the result of the absolute low level of rates as well as the generally wider spread levels of municipal bonds. But the results are significant: Simply stated, investors are able to buy 30-year AAA municipal securities that out-yield a 30-year U.S. Treasury bond on a pretax basis. After taxes, investors further benefit from the tax-free income offered by municipal bonds. 6 Putnam Investments. PUTNAM INVESTMENTS putnam.com 5

6 Figure 8. Spreads remain elevated at higher credit ratings Historical municipal spreads (bps), 1/30/99 1/17/ AA A BBB Source: Putnam Investments, as of 1/17/12. Implementing an investment strategy To summarize the municipal bond landscape: Credit fundamentals are weathering the storm much better than anticipated Defaults remain low Credit spreads and muni/treasury ratios are attractive relative to historical levels Research and active management are even more important after the virtual disappearance of bond insurance But what is the best way to implement a municipal bond strategy given the changes in the marketplace and the current environment? A portfolio of laddered individual bonds or shares of a mutual fund? Investment grade or high yield? National or state-specific? There are several ways to implement a municipal strategy, and the primary consideration must always hinge on what is suitable for the individual investor. Assuming that risk tolerance, time horizon, etc., is determined, one or more of the methods of implementing a municipal strategy may be appropriate. In many cases, a municipal bond investment strategy will consist of a concentrated number of individual bonds laddered by maturity date. Without being able to rely on bond insurance to provide a guarantee of principal and interest payments, the research and review of an issuer and the provisions of the security are more important than ever before. There are approximately 50,000 issuers in the municipal market, and they are far from uniform, with each having its own specific nuances relating to the bond covenants or some aspect of that particular bond structure. Unfortunately, many advisors and investors may not be aware of the best way to find the necessary information on the bond or may not have the time or expertise to do the thorough review needed to avoid potential pitfalls. Relying on rating-agency designations provides some relative sense of quality, but that first step is not a sound credit strategy in and of itself and, we believe, is not an optimal way to avoid the potentially large losses an investor could face in a portfolio with only a few individual bond holdings. Investing in funds is a good way to leverage vastly greater diversification benefits as well as professional fund management coupled with the expertise of a seasoned research team. Fundamental research, when properly implemented, can help mitigate risk by identifying potentially deteriorating credits in the municipal bond market, which may either be sold from the portfolio or avoided altogether. This capacity is of heightened importance today with the far less prominent role of bond insurance and issuers continuing to work their way through the financial crisis. PUTNAM INVESTMENTS putnam.com 6

7 Figure 9. Long-dated munis are out-yielding comparable Treasuries even without the tax advantage Muni/Treasury ratios Averages Standard deviation Jan. 20, 2012 Since 1990 Since 1998 Since 2000 Since 1990 Since 1998 Since years 92% 80% 83% 84% 12% 14% 15% 10 years years Sources: MMD, Bloomberg, Putnam Investments, as of 1/20/12. An actively managed fund also provides a vehicle that may trade opportunistically, typically at lower costs due to more efficient block trading. Moreover, the manager may employ strategies such as sector or quality rotation, and more flexible yield curve positioning, both of which are difficult if not impossible for investors building their own laddered portfolios. Additionally, investors are able to redeem a portion or all of their investment at any time, while individual bonds can be difficult to liquidate. 7 Funds also typically pay regular, monthly income, although that income typically fluctuates and is not fixed. That being said, a fund is a more transparent vehicle, with market moves reflected in the calculation of net asset value on a daily basis. Lastly, it is worth noting that fees may potentially be higher in a mutual fund than in a laddered portfolio due to greater administration costs. Given the many benefits of using a mutual fund to access the municipal bond market, investors using a portfolio of laddered bonds may consider adding a fund as a complement to their existing holdings. For example, if the investor owns primarily AA-rated bonds, it may make sense to invest the proceeds of the next maturing individual bond into a tax-free high-yield fund, which could potentially add quality diversification as well as increased yield. Alternatively, the investor may own several state-specific bonds. Adding an investment in a national municipal bond fund can dramatically broaden the investor s diversification. In sum, introducing actively managed municipal bond portfolios could add greater diversification and more thorough risk mitigation, and provide a broader opportunity set for increasing value. While the municipal market has evolved in recent years, municipal bonds remain strategically important investments with significant tax advantages and generally low correlations to other asset classes over time. Currently, we believe this may be an attractive entry point for municipal bond investors, and one way to do that is to use actively managed funds in place of or as a complement to individual bonds. Relying on professional managers and deep research teams to take advantage of timely opportunities provides not only the potential for additional return for investors but broader diversification and risk mitigation in a market environment that is much more challenging to navigate today than it was only ten years ago. 7 Share price, principal value, and return will vary, and there may be a gain or a loss when shares are sold. In addition, review the fund prospectus as certain funds may enforce short-term trading policies. Fundamental research, when properly implemented, can help mitigate risk by identifying potentially deteriorating credits in the municipal bond market, which may either be sold from the portfolio or avoided altogether. PUTNAM INVESTMENTS putnam.com 7

8 Thalia Meehan is a Portfolio Manager within Putnam s Tax Exempt Fixed Income Group. She earned a B.A. from Williams College, is a CFA charterholder, and has worked in the investment industry since She is a member of the Boston Security Analysts Society and the Society of Municipal Analysts. Paul Drury is a Portfolio Manager within Putnam s Tax Exempt Fixed Income Group. He earned a B.A. from Suffolk University, is a CFA charterholder, and has worked in the investment industry since Susan McCormack is a Portfolio Manager within Putnam s Tax Exempt Fixed Income Group. She earned a B.A. from Dartmouth College and an M.B.A. from Stanford University, is a CFA charterholder, and has worked in the investment industry since The views and opinions expressed are those of the authors, are subject to change with market conditions, and are not meant as investment advice. Companies and municipalities referenced may or may not be Putnam fund holdings. Consider these risks before investing: Capital gains, if any, are taxable for federal and, in most cases, state purposes. For some investors, investment income may be subject to the federal alternative minimum tax. Income from federally exempt funds may be subject to state and local taxes. Funds that invest in bonds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Unlike bonds, bond funds have ongoing fees and expenses. Diversification does not assure a profit or protect against loss. It is possible to lose money in a diversified portfolio. Data is historical. Past performance is not a guarantee of future results. As with any investment there is a potential for profit as well as the possibility of loss. Request a prospectus, or a summary prospectus if available, from your financial representative or by calling Putnam at The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. EO /12