California Municipal (CA Muni) Market Update

Transcription

1 Investment Viewpoints Colleen Ambrose Vice President, Client Portfolio Manager California Municipal (CA Muni) Market Update Current credit and market conditions influencing the performance and strategies of American Century Investments CA Tax-Free and Muni funds April 2010 Rich Taylor Vice President, Client Portfolio Manager FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE

2 Key Points We continue to believe CA is highly unlikely to default (miss payments) on its general obligation (GO tax-supported) debt. The January 2010 downgrade of CA s GO debt by Standard & Poor s (S&P) from A to A did not change our credit outlook for the state s GO bonds. Even with the latest downgrade (which followed similar downgrades by Moody s and Fitch last summer), CA s GO debt continues to be rated investment grade by all three rating agencies. (Moody s and Fitch have rated the state s GO bonds Baa1 and BBB, respectively, since July, 2009.) Under its constitution, the state is required to pay debt service on its GO bonds the legislature cannot repeal a debt service payment and GO debt has second claim to all general fund revenues, behind only education. In addition, as a state, CA cannot file for bankruptcy, and it cannot disappear, like a corporate credit. Our long-term muni outlook is positive, in terms of the legislative environment and demographics. We believe taxes must rise over time given massive federal and state budget deficits, making munis increasingly appealing for high-net-worth individual investors. Potential CA muni fund investors who are CA residents already pay some of the highest taxes in the U.S. These rates are likely to rise as budget deficits mount, increasing the benefits of tax-free CA municipal bond interest income to state residents. In addition, President Bushera tax cuts are set to expire in Unless Congress acts to renew those cuts, which seems unlikely, in our view, tax rates will revert to previous, higher levels. Furthermore, an aging population of increasingly income-oriented investors is also likely to support demand for munis over time. We believe the near-term muni market outlook is mixed. Short-term positives: In the near term, supply and demand are likely to remain positive for the muni market. Muni analysts estimate 2010 will see the lowest supply of tax-exempt munis in about seven years. That s because of a federal program (Build America Bonds) intended to improve access to capital markets and reduce borrowing costs for municipalities, which has resulted in much new muni issuance coming in the form of taxable bonds. At the same time, attractive muni yields relative to cash and Treasuries suggest demand can also be a positive in the near term. Short-term muni market negatives: They are mostly economic and credit-related the lingering impact of the Great Recession and credit crisis will continue to weigh on incomes and tax revenues in 2010, resulting in pressures on municipal budgets. We believe most muni issuers can withstand these pressures without defaulting. As S&P wrote in a Credit FAQ on December 16, 2009: While we think that state and local governments are, and will continue to come, under pressure that will cause them to make tough fiscal choices, we do not expect defaults or downgrades to be as frequent as they have been in the corporate sector. Besides financial pressures, munis will also be subject to headline risk market volatility (investor reactions) resulting from news headlines about credit rating downgrades and budget deficits. This post-recession market favors effective muni credit analysis and careful security selection. We offer decades of experience in these areas. In current market conditions, we favor high-quality essential service revenue bonds, such as water and sewer utility bonds. In general, we re likely to continue to favor bonds from less economically sensitive segments of the market, as well as those that offer an attractive combination of yield, quality, and structure. FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE 2

3 Latest Major CA Development/Headline Risk S&P downgraded CA s credit rating from A to A On January 13, 2010, S&P downgraded CA s credit rating from A to A because of likely challenges in closing the $20 billion gap in the state budget. S&P said it was concerned about overly optimistic assumptions built into the proposed budget around the amount of federal support the state could expect. In addition, CA faces its usual challenges of needing a two-thirds legislative majority to approve a budget, voter-mandated spending requirements for education, and highly variable revenue streams that have been hit hard by the downturn in the economy and housing market. Moody s and Fitch are standing pat so far, after having already cut the state s ratings to Baa1 and BBB, respectively, in Questions and Answers (with David Moore, Credit Research Director for all American Century muni funds, and Joseph Gotelli, a portfolio manager for California Tax-Free Bond and California Long-Term Tax-Free) Does the S&P rating downgrade increase the odds of CA defaulting on any of its GO debt? We believe it is highly unlikely the state will default on its GO debt. Despite its very serious problems, CA has more than enough revenue to make principal and interest payments on its GO bonds. CA s annual debt payments are about $6 billion per year, and they re still well covered by annual state tax revenues (estimated to be about $83 billion in fiscal year ), even after you deduct the 40% of those total revenues set aside for its schools. (CA GO bonds have second claim to all general fund revenues. By state law, state schools are entitled to 40% of revenues, then the remainder [about $50 billion] is available for bondholders.) Also, CA is required by state constitution to pay debt service on its GO bonds. Furthermore, we think it s highly unlikely that CA would threaten its future access to the capital markets by defaulting on debt service that amounts to just 7% of its revenues. And finally, in an absolute worst-case scenario, we think the federal government would likely step in to prevent CA from defaulting, given that the state represents 13% of U.S. gross domestic product. Background: An A- or BBB-rated credit in the muni market is a much stronger credit than a BBB credit in the corporate market, for the simple reason that muni issuers are much less likely to default than their corporate counterparts. As Gabe Petek, a director in S&P s bond rating group said in a 2009 article, CA is a sovereign entity. He added: No matter how difficult the financial and economic conditions get, it can t just go away. It s not like Circuit City [the large consumer electronics retailer that filed for bankruptcy in 2008 and liquidated its assets in 2009]. Will the CA muni market experience increased volatility (spread widening an increase in CA muni yields versus those of the highest-quality muni issues) as a result of the credit rating downgrade or was the rating cut already pretty much priced in? The January 2010 rating downgrade was already pretty much priced in at the time it happened, especially in the long-term market. Market participants noted that spreads on the state s 30-year GO debt were essentially unchanged in the wake of the downgrade. This reflected the extent to which CA s budget problems were well telegraphed and are widely understood in the marketplace, at least by large, institutional investors who tend to be buyers of longer-term munis. FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE 3

4 Will American Century CA portfolios be buyers of new CA GO issuance? Why or why not? We added long-term CA GOs in 2009 at what we considered to be very attractive yields. Now that the CA GO positions in our CA investment-grade bond portfolios are at basically neutral weightings, we re not highly motivated to add to them at this time, given the mixed nearterm muni outlook that we highlight in our Key Points. However, as the year progresses, we ll continue to evaluate opportunities to add to these positions when market volatility presents opportunities to buy more bonds at higher yield/lower price levels. What s the outlook for smaller CA issuers, such as cities and counties? Our outlook on local government issuers such as cities, counties, and school districts is they will be under significant financial pressure due to (1) declining revenues, (2) reduced state aid, and (3) in the case of cities and counties, potential state raids of gas taxes. That being said, we don t think there will be widespread defaults among local issuers, but there will be some isolated defaults, especially with some smaller cities in the state. Most of the state s local governments, especially the cities and counties, built up significant reserves during the nonrecession years, as there s a long history of the state diverting funds away from them. And unlike the state, most local issuers have taken quick action to reduce their expenses to bring them in line with their lower revenue estimates. As with the state, we feel the real risk for holding local issuer bonds is rating and headline risks. There will most likely be a significant number of downgrades over the next couple years as local issuers draw down their reserves and budget savings get harder to come by. What s the current state of the CA high-yield bond market? We are in a difficult credit environment for lower-rated, economically sensitive issuers. While municipal defaults are rare, some high-yield issuers in this weak economy will face difficulties meeting their payment obligations. These challenges mean investors in CA high-yield munis should be prepared to accept some price volatility. While yields and return potential in this sector can be attractive, risks are also prevalent. Indeed, consider that the American Century CA High-Yield Municipal fund (Investor Class) suffered a double-digit decline in 2008, before rebounding in double digits in While we do not expect a repeat of such price volatility in 2010, the last two years go a long way toward illustrating the greater risk and reward potential associated with high-yield bonds relative to investment-grade debt in the current market environment. Given the prevailing economic and credit conditions, we believe credit analysis and individual security selection are crucial to successful investing in the high-yield space. In addition, sector and industry allocation can also be important determinants of return, given the differing economic sensitivities of market segments. In this environment, we tend to favor essential service providers, such as the issuers of water, sewer, electric power, state highway, high-quality healthcare, and higher education bonds. At the same time, we have tended to underweight lower credit quality sectors such as tobacco, airline, industrial development revenue, and pollution control revenue bonds. FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE 4

5 In conclusion, if a high-net-worth CA resident were to ask you: Why should I invest in a CA muni fund, and why should it be managed by American Century Investments?, what would you say? We d likely respond with these four key points: 1. We believe the long-term CA muni market outlook is favorable, particularly for high-networth state residents looking for tax-free income and diversification from other bond sectors and equities. As the economic recovery takes hold and if tax rates increase, munis are likely to outperform U.S. government bonds that are effectively lower-yielding (on a tax-adjusted basis) and are sensitive to economic improvements. CA is already a high-tax state, and tax rates are likely to rise further to address growing budget deficits. 2. CA has a huge, diversified economy and covers a large geographic region; it is larger than many countries and its economy ranks among the top ten in the world. As a result, CA offers a wide spectrum of municipal issuers and bonds by county, city, sector, industry and geographic location, far beyond the state government itself. We believe most CA resident investors who own diversified CA muni fund portfolios would not necessarily benefit by diversifying their muni holdings into other states. For one thing, their out of state muni holdings would not produce state tax-exempt income like CA munis, a benefit for high net worth individual CA investors that we believe would be hard to replace with any measurable diversification benefit from investing out of state. 3. American Century Investments has an exceptionally experienced CA muni portfolio management and credit research team, based in CA (in Mountain View, in the San Francisco bay area). Team leader Steven Permut has successfully managed CA muni portfolios and analyzed the CA muni credit market for American Century Investments since 1987, and most of his team has over 10 years experience working with Steven at American Century Investments through previous recessions, CA budget crises, and market cycles. 4. American Century s three CA tax-free and muni bond funds California High-Yield Municipal, California Long-Term Tax-Free, and California Tax-Free Bond have strong, longterm track records and are well-regarded within the fund industry, each earning four stars as of March 31, 2010, for their life of fund, Investor Class, performance. Writer: John Eichel Overall Morningstar Ratings are based on risk-adjusted returns and reflect the weighted average of the fund s 3-, 5- and 10-year rankings, as applicable. The Overall Morningstar Rating TM for a fund is derived from a weighted average of the performance figures associated with its three-, five- and ten-year (if applicable) Morningstar Rating TM metrics. As of March 31, 2010, California High-Yield Municipal and California Long-Term Tax-Free were rated against the following numbers of U.S.-domiciled Muni CA Long funds over the following time periods: 156 funds in the last three years, 143 funds in the last five years, and 119 funds in the last ten years. With respect to these Muni CA Long funds, California High-Yield Municipal received a Morningstar Rating TM of 3 stars for the threeyear period, 4 stars for the five-year period and 5 stars for the ten-year period. With respect to these Muni CA Long funds, California Long-Term Tax-Free received a Morningstar Rating TM of 4 stars for the three-year period, 4 stars for the five-year period and 4 stars for the ten-year period. As of March 31, 2010, California Tax-Free Bond was rated against the following numbers of U.S.-domiciled Muni CA Intermediate/Short funds over the following time periods: 71 funds in the last three years, 66 funds in the last five years, and 40 funds in the last ten years. With respect to these Muni CA Intermediate/ Short funds, California Tax-Free Bond received a Morningstar Rating TM of 4 stars for the three-year period, 5 stars for the five-year period, and 4 stars for the ten-year period. Past performance is no FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE 5

6 guarantee of future results. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating TM based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund s monthly performance (including the effects of sales charges, loads and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.) Before investing, carefully consider these funds investment objectives, risks, charges and expenses. Contact for a prospectus or summary prospectus (if available) containing this and other information. Read it carefully. Because the funds invest primarily in California municipal securities, their yield and share price will be affected by political and economic developments within the state. Investment income may be subject to other state and local taxes and, depending on the investor s tax status, the federal alternative minimum tax. Capital gains are not exempt from federal income tax. The funds are state tax-free only in the state indicated in the fund name. Not available for purchase in all states. Investment return and principal value will fluctuate and it is possible to lose money by investing. The opinions expressed are those of the investment managers and are no guarantee of the future performance of any American Century portfolio. Statements represent personal views and compensation has not been received in connection with such views. This information is not intended to serve as investment advice. This communication was written in connection with the promotion or marketing, to the extent permitted by applicable law, of the transaction(s) or matter(s) addressed herein by persons unaffiliated with American Century Companies. American Century Companies and its affiliates do not provide tax advice. Accordingly, to the extent this communication contains any discussion of tax matters, such communication is not intended or written to be used, and cannot be used, for the purpose of avoiding tax penalties. Any recipient of this communication should seek advice from an independent tax advisor based on the recipient s particular circumstances. P.O. Box Kansas City, MO American Century Investment Services, Inc., Distributor 2010 American Century Proprietary Holdings Inc. All rights reserved. IN-FLY FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE 6