Politics still the great wild card for tax-exempt fund managers
Despite dire predictions a few years ago that municipalities would default in droves, Ronald Schwartz never seemed to break a sweat. The manager of the $1.1 billion RidgeWorth Investment Grade Tax-Exempt Bond Fund maintained his enviable record amidst all the apocalyptic talk, having beaten some 96 percent of his peers over the last 15 years with a 5.65 percent annualized return.
The defaults never materialized on the scale that the Chicken Littles envisioned. But with a fiscal cliff -- the combination of $600 billion in automatic spending cuts and tax hikes -- looming, Schwartz is a little more skittish than usual. If there's one thing money managers don't like to predict, it's politics. Schwartz and RidgeWorth credit analyst Philip Hooks spoke with Lewis Braham about how to invest in a time of such uncertainty.
Q: What issues will drive the municipal bond market in 2013?
A. Schwartz: One is how the issue of the fiscal cliff will be approached. That will affect not just the muni market but all markets. You'll have to study that to see what it signals for another major issue, tax reform. Both parties will have to work towards some resolution. It's just a matter of how the battles are played out and hopefully it doesn't come to crisis mode. When it comes to politics, it's very hard to forecast so we tend to react instead.
Q: What if the fiscal cliff issue isn't resolved?
A. Schwartz: If nothing's resolved, the U.S. economy in all probability will go into a recession again. I think there will be something done, but you don't know if it will be a temporary fix or a true compromise and program that resolves both the fiscal and tax issues.
Q: Do you think the uncertain environment favors high quality municipal bonds?
A: Schwartz: With more unknowns, you usually get more volatility. We've seen people reaching for yield and not being adequately compensated for the credit risk they're taking. When we eventually have an environment with more volatility, the higher-quality paper will hold up a lot better than lower-quality credits, especially with spreads [the difference in yields] already being so narrow between them.
Q: What about investors who'd rather take credit risk because they think rising interest rates are the bigger threat to bond prices?
A: Schwartz: If you're buying a low-quality bond for the yield and will hold it until maturity no matter what, that's an acceptable way to look at it. If you're saying if rates go any higher I may want to get out of this bond, trade it and buy some alternative investment, your liquidity might be substantially less in the low-quality bond than in the high-quality one. In a bear market, bids on junk can be very thin and difficult.
Q: What is your outlook for municipal credit quality?
A. Hooks: There are certainly things with the great recession we had that place stress on municipalities. The positive thing people miss is many of the cities, counties and towns we invest in have taken appropriate measures to prepare for and react to the reduction of tax revenues they've seen. They've been able to, for the most part, balance their budget. They've made tough choices in terms of layoffs, but the larger higher-quality issuers have responded very well because of the depth of their management and experience.
Q: What types of municipal bonds do you favor?
A. Hooks: One would be essential service bonds such as water, sewer, power and some transportation bonds. You have a dedicated revenue stream. You haven't seen reductions in use of power and water and other essential services even in bad times. We selectively like general obligation or GO bonds, [which use general tax revenues to pay off the bond]. With GOs, we tend to like larger municipality issuers, such as Dallas, with large amounts of cash on their balance sheets and larger revenue streams. We feel like they're more able to handle fiscal stress if a state cuts back its revenue payments to counties.
Q: What municipalities are you concerned about in 2013?
A. Hooks: California -- we've had some issues there. Does that mean there aren't still a lot of solid credits in California? No. But there have been more bankruptcies there. California has a very stringent government system. Until recently it took a super-majority to pass budgets. They have regulations that limit the amount local governments can raise property taxes, and they have a large amount of entitlements. They have large expenses for education, prison system, the things they must provide for their citizens. You've seen more stress on some small local governments and that's where the majority of bankruptcies have been.
Q: Are there other states you worry about?
A. Schwartz: We're watching Illinois and Puerto Rico. In Illinois they have fiscal budgetary pressures from the pension plans of municipal employees. In Puerto Rico there are fiscal and political pressures. Some Puerto Rico credits were recently downgraded.
Q: A lot of muni funds have significant weightings in Puerto Rico. Why?
A. Schwartz: The bonds are state-tax exempt [regardless of the state of your residence]. A lot of state-specific muni bond funds invest heavily in Puerto Rico paper because the yields are very high, especially compared to other state-specific alternatives. We are very conservative. The diversified funds I manage have no Puerto Rico exposure.
Q: What muni bond maturities offer the best tradeoff between risk and return?
A. Schwartz: There's no reason to buy a 30-year bond as opposed to a 25-year bond. The difference in yield is only 0.05 percentage points. We find 10-year bonds attractive. The yield on an AA-rated 5-year bond is 0.80 percent while on a 10-year it's just under 2 percent.
--Bloomberg News--
(Lewis Braham is a freelance writer based in Pittsburgh.)
