Q&A: Baird Advisors Portfolio Manager Warren Pierson Addresses Municipal Credit Market Concerns

Challenges Likely to Persist, Pervasive Bankruptcies Unlikely

 
MILWAUKEE, February 11, 2011

As Congress convenes hearings to address credit issues in the municipal market, many investors have questions about the outlook for municipal bonds and municipal bond funds. Baird Advisors Senior Portfolio Manager Warren Pierson, lead mana
ger ofBaird Intermediate Municipal Bond Fund, recently shared his thoughts on what lies ahead.

Q: What drove the downturn in the municipal market during the last two months of 2010? What’s your fund management strategy against volatility?

Q: Should people be concerned about the financial health and creditworthiness of municipalities? Why or why not?

Q: How do you manage the risks associated with bonds issued by municipalities that are in ill financial health?

Q: Is it possible that increased focus on general-obligation munis --those funded by tax revenues – will cause them to become overpriced relative to revenue bonds?

Q: Are there any states or municipalities whose bonds you’re avoiding? How likely is the federal government to provide a backstop in case of default?


 

Q: What drove the downturn in the municipal market during the last two months of 2010? What’s your fund management strategy against volatility?

Pierson:
A confluence of several factors led to an acute supply/demand imbalance that resulted in the sharp sell-off in municipals late in the year.

Supply
- Congress’ decision to discontinue the Build America Bonds program (BABs, which are taxable municipals) led to a surge in BABs supply as issuers tried to beat the December 31 deadline. Dealers, already awash in heavy corporate supply, had trouble distributing all these new issues (and hedged unsold inventory by selling Treasuries) and taxable yields started spiking which, in turn, put upward pressure on tax-exempt municipal yields, especially on longer maturities. BABs represented about 30% of municipal supply in 2010, but comprised almost two-thirds of long issuance. In anticipation of heavier 2011 issuance, many municipal entities tried to beat the expected rush and the supply of new tax-exempt issues also rose late in 2010.

Demand -
At the same time that supply was surging, demand for municipals was falling. General investor enthusiasm for bonds began to cool in the 4th quarter as more encouraging economic numbers started raising concerns about inflation (along with rising prices for food, oil and many commodities). The sharp increase in Treasury yields fueled these concerns. The extension of the Bush tax cuts also reduced marginal demand for municipals from investors who had been assuming that their federal income tax rates would be rising. Finally, Meredith Whitney’s prediction of pervasive municipal defaults spooked investors and accelerated the selling pressure that had been brewing. Tax-exempt bond mutual fund inflows that had averaged $3.5 billion per month through September flipped to outflows of -$7.6 billion in November and -$13.4 billion in December. Prices plummeted and yields spiked as tepid demand was quickly swamped by heavy primary and secondary supply.

Volatility - Price declines in the market were most severe on the long end of the yield curve and in lower quality issues. Being an intermediate fund with a high quality bias, the Baird Intermediate Municipal Bond Fund weathered the recent volatile environment very well. The Fund’s emphasis on prerefunded issues (65% of market value) provided a strong base of protection against significant price declines. Additionally, minimal exposure to callable issues also protected the Fund from the painful and plentiful duration extensions experienced in the market. As yields rose, many bonds in the market that in prior months had been priced to their shorter calls were suddenly being priced to their longer maturity dates. The resulting duration extensions were particularly painful as those bonds rolled up and out the steep yield curve to higher yields and sharply lower prices.

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Q: Should people be concerned about the financial health and creditworthiness of municipalities? Why or why not?

Pierson: For the past two years, we have warned about a changing landscape in municipal credit and expressed concern about the financial health and creditworthiness of municipalities. We believe that the challenges currently confronting many municipal issuers will persist in the coming years. However, we do not believe the municipal market will experience pervasive bankruptcies and defaults as has been predicted by a few. We do believe that the vast majority of municipal issuers will find ways to raise revenue and/or cut expenses in order to service their debt on a timely basis. For example, the State of Illinois recently increased its marginal income tax rate from 3% to 5% in an aggressive step to address their budget shortfall.

Having said that, we do anticipate an increase in the number of municipal defaults, but we believe they will be limited to a select number of issuers with extenuating circumstances (e.g. some specific purpose revenue bonds and/or G.O.s of communities with exceptionally high unemployment and/or profound declines in population and property values). We expect that ratings downgrades will become more prevalent leading to associated price declines for affected issues. We advise investors against going too far out the yield curve or too far down in quality at this juncture.

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Q: How do you manage the risks associated with bonds issued by municipalities that are in ill financial health?

Pierson: One big step to avoid bonds of municipalities that are in ill health is owning prerefunded issues. Prerefunded bonds are secured by US Government securities held in irrevocable escrow accounts and offer exceptional protection from municipalities facing financial difficulties. Apart from our prerefunded holdings, we look for bonds that are supported by broad and deep streams of revenue (e.g. G.O.s and essential service revenue bonds of larger communities) and generally avoid issues and sectors relying on more narrow or shallow revenue streams. These would include bonds supported solely by revenues from a special purpose facility such as a parking structure or convention center. We are also wary of G.O.s or more general revenue bonds of communities that may not have the wherewithal to raise additional revenue if required. Red flags that may cause us to avoid such issuers or municipalities completely would include population declines, high unemployment and significant declines in property values. Communities facing these challenges could find it difficult to levy (and collect) the taxes needed to service their debt.

Diversification is always a key element in managing risk. We believe that individuals benefit greatly from investing in mutual funds that are professionally managed and very well-diversified. Mutual funds also provide better liquidity to those investing in the municipal market where the buying and selling of individual issues is often challenging and costly.

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Q: Is it possible that increased focus on general-obligation munis --those funded by tax revenues – will cause them to become overpriced relative to revenue bonds?

Pierson: In the last year, we have noticed a tiering in the market between those bonds that are viewed as “safe” by investors (typically AAA and AA-rated G.O.s and essential service revenue bonds) and other bonds that may be more prone to experience difficulties. These other bonds are not necessarily destined for trouble, but they trade at higher yields because of the additional perceived risk. While G.O.s have historically been viewed by many investors as a “completely safe” sector, we caution that changing conditions in municipal credit warrant closer scrutiny. As a result of the preference in the market for higher rated G.O.s and essential service revenue bonds (e.g. water/sewer), we do believe that some of these issues are overvalued in light of their underlying credit dynamics. Downgrades and the impact of associated price declines are of particular concern. The current yield spread between 10-year AA and A credits is approximately 70 basis points (0.70%). Based upon this spread of 70 bps, a 10-year bond falling to A from AA would likely experience a price decline of 5-6%. Furthermore, it is very difficult for the rating agencies to perform ongoing reviews on the thousands of municipal credits they cover, and it is our contention that, given the dramatic change in municipal credit conditions over the past couple years, downgrades will be prevalent (and in some cases severe) as they update their ratings. Buying bonds at the right price level is very important and, as always, it is very easy to overpay for a bond.

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Q: Are there any states or municipalities whose bonds you’re avoiding? How likely is the federal government to provide a backstop in case of default?

Pierson: States by definition have broader revenue bases and more flexibility in cutting costs to help balance budgets and as such, are perceived in the market as “better credits” than a lot of other municipal issuers. While we would generally agree with this consensus view, we caution that credit fundamentals vary greatly from state to state and there are a handful of states that we have avoided because of credit concerns. California is one of them. Being the biggest state, it clearly has very broad revenue sources, but it also already has very high income and sales tax rates and a populace that seems reluctant to accept austerity measures, so closing structural budget deficits will be a challenge. Additionally, many parts of California have experienced some of the sharpest declines in property values and unemployment stands at 12.3% (as of 12/31/10). While we believe that a default on California State G.O. debt is unlikely, we believe that negotiating a credible budget will be very difficult and would anticipate increased discussion and press coverage of the possibility of a default in coming quarters. Price volatility will likely accompany these negotiations and the potential threat of a downgrade (from A to BBB) through these negotiations would certainly amplify that volatility. While we believe that the federal government would not like to see a state default, we would not want to rely on a federal bailout and believe that any bailout could well be part of a broader reorganization (e.g. maturity extension, coupon reduction) that could still be detrimental to bond holders. We believe that default risk is significantly greater with “downstream” municipalities that will suffer directly from budget cuts at the state level and also believe the federal government will be more reluctant to set the precedent of a “bail-out” at the local level given that there are literally thousands of local issuers. Municipalities that we have avoided include Las Vegas and Detroit.

The Wall Street Journal says municipal bond disclosure needs to improve -- do you agree? How can investors get the details they need to make informed decisions?

Pierson: We would agree that municipal disclosure is not as good as it should be; financial information is often dated and all too frequently non-existent. We see this as confirmation that it is much more of a priority for issuers (and rating agencies) to successfully issue new debt and less of a priority to provide updates on their ongoing financial condition. In our investment decision making process, when we do not believe there is sufficient information to make an informed decision, we take a pass on the bond. While this may result in missing some opportunities, we believe that investors in this asset class are primarily concerned about wealth preservation (as opposed to wealth generation) and thus, erring on the side of caution makes good sense. In the Baird Intermediate Municipal Bond Fund, we have always maintained an extremely high quality bias and have focused on more predictable relative value strategies such as yield curve positioning, sector allocation, security selection and competitive execution. We believe this provides a strong value proposition for high net worth individuals, particularly in the present environment where confidence in municipal credit has been shaken profoundly.

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About Baird
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 2,600 associates serving the needs of individual, corporate, institutional and municipal clients. Baird oversees and manages client assets of nearly $82 billion. Committed to being a great place to work, Baird ranked number 14 on FORTUNE’s “100 Best Companies to Work For” in 2011 – its eighth 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 rwbaird.com.

 

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In a rising interest rate environment, the value of fixed-income securities generally declines and conversely, in a falling interest rate environment, the value of fixed-income securities generally increases. While individual bonds can be held to maturity with the intention of delivering par value, investment return and principal value of an investment in bond funds will fluctuate so that an investor's shares when redeemed, may be worth more or less than their original cost.

Municipal bonds are not suitable for all investors, especially those in a lower tax bracket. Please visit emma.msrb.org for more information about municipal securities.

Diversification does not endure against loss.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.