Baird Intermediate Municipal Bond Manager Positions Fund for Potential Downgrades, Volatility
MILWAUKEE , August 25, 2010
Municipal market credit challenges have lagged the nearly unprecedented difficulties experienced in the corporate market in 2008. Baird Intermediate Municipal Bond Manager Warren Pierson, CFA, believes continued caution is warranted.
“We have been saying for a while that the municipal credit landscape is changing,” said Pierson. “Revenues for many corporations fell sharply and nearly immediately as the credit crisis developed in late 2008, but softness in municipal revenues has taken a year or more to surface. As investors were seeing conditions in the corporate market improve dramatically in mid to late 2009, many concluded that the worst for the bond market was behind them. Accordingly, many investors were caught off guard to see that conditions for many municipalities were just starting to deteriorate at that same time.”
According to Pierson, this natural lag in the decline of municipal revenues—such as property taxes, sales taxes and income taxes—resulted from lower property values, softer consumer spending and higher unemployment/lower wages.
Accustomed to decades of steadily-increasing top line revenues, municipalities have struggled to balance budgets as the swift decline in revenues has led in some cases to structural deficits. Many one-time fixes such as selling buildings have been applied as stop-gap measures to balance budgets for a particular year, but persistent structural deficits are becoming more difficult to address as revenues remain soft. “While outright reductions in expenditures may be necessary, cutting spending is unpopular and often politically difficult to achieve,” added Pierson
Potential Bond Downgrades or Defaults
In response to weaker financial positions, Pierson is expecting lower ratings and corresponding price declines. Even in historically stable sectors such as general obligation bonds (GOs), new financial challenges could result in downgrades. In 10-year maturities, the difference between yields on AA-rated issues and A-rated issues is approximately 60 bps. A downgrade from AA to A could mean a price decline of up to 5%. BBB yields in the 10-year range are over 100 bps higher than yields on A-rated issues, leading to a potential price decline of 8% or more for a downgrade from A to BBB.
As revenues decline, some issuers may not be able to service their debt, raising the potential of increased defaults. This is a greater risk to bonds with more narrow revenue sources such as a parking structure or convention center. But even some GO issues could be at risk if financial conditions are severe. Examples would be a fast growing community that financed and built schools in expectation of continued population growth and expansion that didn’t materialize or an established community that has experienced severe declines in property value, high unemployment and declining population.
Said Pierson, “While we believe the probability of widespread defaults is low, issues with limited, questionable or contingent revenue sources are clearly at greater risk and we have already seen the market place a liquidity premium on such issues. We are also concerned that issuers between a rock and a hard place could look to bond holders for concessions.”
According to Pierson, if confronted with the options of 1) raising taxes on already burdened constituents, 2) cutting social services or programs to people at risk or 3) laying off teachers or other municipal workers, municipalities could view asking bond holders to “share in the pain” as part of a solution for the greater good of all. “Historically there has been a very strong stigma associated with defaulting and hopefully that will persist. However, the stigma will fade if more issuers choose to take this path.”
As the market prices in these perceived risks, Pierson expects we will see significant price volatility on individual issues. “We have seen several intermediate issues trade in the secondary market as much as 5 points below where the pricing service had been pricing them.”
In addition to price volatility, the specter of illiquidity is a concern. Due to the market’s concern about the potential risks, liquidity in certain issues can be limited and transaction costs can be significant, particularly on smaller pieces.
“Given the changing landscape, we recommend that investors exercise caution in the municipal market,” advises Pierson. “The municipal market has long been considered a close second to Treasuries by investors in terms of quality. While still a high quality market overall, the municipal market has changed in recent years. Many municipalities find themselves in unchartered waters, and investors navigating these current waters with the same strategies they have used in past decades could be in for some unpleasant surprises.”
Pierson also cautions against going too far down in credit quality or too far out the yield curve. “We believe higher quality, intermediate issues offer investors the bulk of the value in the market, yet provide significant protection from downside risks.”
Pierson believes diversification is the key. Building a typical bond ladder with 10 or 20 issues results in 5-10% exposure per issue – problems with even one holding could have a significant impact on the overall portfolio. “We firmly believe that most investors are better served by using a fund where exposure to credit risk of individual issues is typically limited to 1% of the portfolio or less.”
About Warren Pierson, CFA
Warren Pierson is Managing Director and Senior Portfolio Manager with Baird Advisors. He has over 24 years of investment experience managing various types of fixed income portfolios. Prior to joining Baird Advisors, Warren was a Senior Vice President and Senior Portfolio Manager with Firstar Investment Research and Management Company (FIRMCO) where he managed municipal bond portfolios and intermediate taxable bond portfolios. A major portion of his time is allocated to yield curve analysis and credit research. He plays a lead role in coordinating and implementing all fixed income strategy at the firm. Warren received his undergraduate degree from Lawrence University and was awarded the Chartered Financial Analyst designation in 1990. Warren is currently a member of The CFA Institute and is past President of the CFA Society of Milwaukee.
About Baird Funds
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Baird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has more than 2,400 associates serving the needs of individual, corporate, institutional and municipal clients. Baird oversees and manages client assets of more than $75 billion. Committed to being a great place to work, Baird ranked number 11 on FORTUNE’s “100 Best Companies to Work For” in 2010 – its seventh consecutive year on the list. Baird’s principal operating subsidiaries are Robert W. Baird & Co. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird’s private equity operations. For more information, please visit Baird’s Web site at www.rwbaird.com.
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