"The municipal market has seen headline risk elevate over the past 18 months. News on Puerto Rico, Detroit and a few California towns has resulted in above average volatility in the market."
Will headline risk continue to impact the muni space as it has over the past 18 months?
The municipal market has seen headline risk elevate over the past 18 months. News on Puerto Rico, Detroit and a few California towns has resulted in above average volatility in the market. However, what is becoming clearer to the marketplace is that these events, although individually concerning, are idiosyncratic in nature and do not represent overall trends in the tax-exempt market. For example, Puerto Rico is territory of the US and does not have the same legal structures and resources as states do. Detroit’s financial position has been deteriorating for many years as population decline and rising costs led to a rare municipal bankruptcy. The California towns were examples of local mismanagement of both benefits and services. Through rigorous credit research, many of these types of issues can be identified early, which can allow a strong investment team in their efforts to navigate away or avoid these problem areas all together. In addition, there are numerous examples of municipalities properly managing their fiscal responsibilities. Pension reform, prudent adjustments to tax rates and balanced budgets, as well as law makers compromising on a bi-partisan basis are some of the positive trends we are seeing. While an isolated example may pop up from time to time, it is our belief that positive trends at the state and local level will mute the few negative stories that may surface in the future.
Explain how high yield munis react differently in a rising rate environment than taxable bonds.
High yield municipal bonds have tended to have less of a correlation to treasury market moves than other fixed income sectors. Unlike corporate high yield, which is normally an unsecured obligation of a for profit entity, high yield municipals are primarily essential service revenue bonds. Essential service bonds are for water, power, toll roads, sewer systems, hospitals and other services that municipalities tend to provide to the public. These services are used in times of economic booms and busts and are things that citizens use every day and several times a day. The user fees and tolls that they charge are directly used to pay the interest on the outstanding bonds and these issuers have the right to increase user fees if they need additional revenue to pay the interest. In addition, if rates are rising because the economy is getting better than our project revenue bonds are most likely improving as well. If we experience credit appreciation, due to a better economy, then the price of lower rated bonds should improve as these bonds rating improve. This possible credit appreciation can also help in a rising interest rate environment. Municipal bonds are issued by state and local government agencies to finance public projects and services. They typically pay interest that is not subject to federal regular income tax or state and local income taxes in their state of issuance. Because of their tax benefits, municipal bonds usually offer lower pre-tax yields than similar taxable bonds.
"We believe that professional portfolio construction, management and credit research are very important in the municipal bond market, particularly right now."
How will rising rates impact a fund's distribution rate in the short and intermediate term? What can you do to try to preserve the distribution rate?
As rates rise, hypothetically we will also be buying higher yielding securities and evaluating relative value opportunities to look for ways to potentially increase yield in the portfolio. Over extended periods of rates rising, we as investors will hopefully have the opportunity to increase the yield in the fund as more, higher yielding opportunities exist.
Why use a bond fund rather than individual bonds? Why high-yield vs. high-grade?
We believe that professional portfolio construction, management and credit research are very important in the municipal bond market, particularly right now. The credit landscape has changed significantly over the last few years as insurance companies have faltered and headline risk has created volatility. Professional management may help in the effort to produce highly diversified portfolios that seek to maximize risk-adjusted returns. Proprietary credit research is an important component of this and allows the management team to selectively choose investments based on relative value, structure and possible credit appreciation. Also, given the municipal market’s segmented and often inefficient nature, it may be difficult for retail investors to access a wide variety of municipal securities. Our position among the top 10 municipal managers allows us the ability to access preferred market opportunities and gain valuable market insight. The Invesco Municipal Team has established relationships with over 120 national and regional tax-exempt debt dealers. These established relationships as well as our size, allow us to achieve execution in daily transactions. Our ability to aggregate trades across multiple funds allows us to obtain lower, institutional pricing which can be additive to performance. We believe that municipal bonds should hold a strategic position in every portfolio. The decision to be invested in high grade versus high yield will be best dictated by an investor’s income needs as well as risk tolerance. That being said, we believe that having exposure to both high yield and high grade can be beneficial given their complementary natures. With high yield munis an investor is tapping into a higher income stream that can potentially dampen long term interest rate risk, however they are also taking on higher volatility and credit risk.
High yield (junk) bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods. Unlike individual bonds, bond funds have fees and expenses and most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
What impact will the decline of rating agencies and insurers have on the future of munis?
We have already seen the impact in the decline of insurers. Despite the insurance wrap, most enhanced municipals trade at prices that reflect their underlying ratings. In other words, they are priced and yield at an appropriate level to their own rating, not the insurance company’s rating. In our opinion, this change in market perception means that investors should assign greater value to proprietary credit research.
At Invesco having a large, experienced staff of analysts that use their own ratings metrics allows us to grade each security separately from the rating agencies and apart from any insurance that may be attached to it. Our team of research analysts completes thorough analysis of current opportunities in the municipal universe as well as on-going surveillance of those issuers held, to identify opportunities to add alpha, which is a measurement of risk-adjusted performance, or reduce exposure to deteriorating credits. Site visits are an important part of our bottom-up fundamental research process. Credit analysts perform anywhere from 100-200 site visits and management conference calls per year. This specialization means that every bond is thoroughly vetted before making it into one of our portfolios.
Are you at all concerned about munis losing their tax-advantaged status?
We continue to monitor the political climate for tax reform and what that could possibly mean for the municipal bond market. We feel that there is a low probability that the tax advantage would be challenged. Within this very low probability we believe that any potential changes would be on a prospective basis – essentially leaving the tax advantage for all existing bonds and only effecting new issues going forward. Municipal entities enjoy a lower borrowing cost and have consistently advocated that this remain in-tact so that they can continue to deliver essential services at a reasonable cost.
A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. NR indicates the debtor was not rated, and should not be interpreted as indicating low quality.
Correlation is a statistical measure of the interdependence of two or more random variables. Fundamentally, the value indicates how much of a change in one variable is explained by change in another.
Alpha is a coefficient which measures risk-adjusted performance, factoring in the risk due to the specific security, rather than the overall market.
Fixed Income Risk. Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Municipal Securities Risk. Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.
High Yield Bond (Junk Bond) Risk. Junk bonds involve a greater risk of default or price changes due to changes in the credit quality of the issuer. The values of junk bonds fluctuate more than those of high quality bonds in response to company, political, regulatory or economic developments. Values of junk bonds can decline significantly over short periods of time.
Securities which are in the medium- and lower-grade categories generally offer higher yields than are offered by higher-grade securities of similar maturity, but they also generally involve more volatility and greater risks.
Management Risk. The investment techniques and risk analysis used by the Fund's portfolio managers may not produce the desired results.
All or a portion of a fund's otherwise tax-exempt income may be subject to the federal alternative minimum tax.
The opinions referenced above are those of Mark Paris as of November 14, 2014, are based on current market conditions and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of other Invesco investment professionals. The comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions, there can be no assurance that actual results will not differ materially from expectations. Past performance is no guarantee of future results. This is not intended to be legal or tax advice. Investors should seek advice from a tax professional.
Diversification does not guarantee a profit or eliminate the risk of loss. There can be no guarantee or assurance that companies will declare dividends in the future or that if declared, they will remain at current levels or increase over time.