Municipal Bonds: Interview with Fund Manager Chris Ryon of Thornburg
Municipal bonds are a great investment choice for high-income-tax-bracket investors. I liked the interview my colleague Ben Shepherd recently did with fund manager Chris Ryon of the Thornburg funds so much that I am reproducing it in full below. Enjoy! — Jim Fink
After several high-profile analysts voiced concerns about the solvency of state and local governments, municipal bonds became the pariahs of the fixed-income universe. But Chris Ryon, one of the trio of managers who head Thornburg Intermediate Municipal A (THIMX, 800-847-0200), sees opportunities in this beleaguered sector. Municipalities continue to face challenges, but they’ve taken steps to get their fiscal houses in order with higher taxes and less spending. Educated investors can pick up bargains as long as they are mindful of hidden risks — Ben Shepherd
Ben Shepherd: What’s the root cause of the volatility in the municipal bond (muni) market?
Chris Ryon: The market was beat up during the fourth quarter and early 2011, as several high profile analysts and investors made public statements questioning the solvency of many municipalities. The negative prognostications of about 50 to 100 municipal defaults running into hundreds of billions of dollars are overblown.
Nevertheless, these predictions have roiled the markets. After about 24 months of positive inflows investors began to take money out of municipal bond funds during the week of Dec. 15, 2010. Billions of dollars exited the market each week. The upside is that this volatility has created opportunities for municipal bond investors.
Ben: What’s your outlook on rates?
Chris Ryon: Over the next six to 12 months, the Federal Reserve should hold interest rates steady and the yield curve should remain extremely steep. The Fed’s made some comments suggesting that its policies will target stock prices. I’m not sure that’s a good thing. But rates for municipal bonds should end the year pretty much where they started.
Ben: Muni funds experienced huge outflows in the fourth quarter. Did the extension of the favorable George W. Bush-era treatment of dividends drive this exodus?
Chris Ryon: No. On a tax-adjusted basis, munis were still relatively attractive when the trouble started. Here’s what really happened. Many analysts had a negative outlook for credit markets. Although their negativity was overdone, it created a negative feedback loop.
People read these comments and took their money out of the muni market. A lot of money has returned, mostly from people who’ve taken their capital out of money market funds because these funds yield almost nothing.
Those investors may not be accustomed to the volatility typical of this asset class. They came in chasing income. They will invest in a variable net asset value (NAV) fund, watch the NAV fluctuate, decide that they don’t have the stomach for the volatility and exit their investment.
We’ve been telling our shareholders that if you come into these funds, you must have an appropriate investment horizon, which we define as two to three years.
Ben: We heard a lot about supply issues in the fourth quarter, when the Build America Bond (BAB) program expired. Is that an accurate assessment?
Chris Ryon: Build America Bonds accounted for about 27 percent of total municipal bond issuance in 2010. In the fourth quarter, particularly in November and December, BAB issuance was between 35 and 37 percent of total municipal issuance.
BABs had to be issued for infrastructure projects; they were part of the economic recovery plan. The big fear was that BABs would go dollar for dollar into tax-exempt issuance after the expiration date. That would increase the supply of tax-free municipal bonds and therefore depress prices. I don’t think that will be the case because these bonds have to be issued for infrastructure projects.
If the cost of funding a project changes and it’s no longer economical, issuers will cancel the project.
New Jersey governor Chris Christie canceled a $3.5 billion commuter train tunnel to New York City because the state couldn’t afford it. Who would have thought that California’s governor Jerry Brown, who people once called Governor Moonbeam, would be a fiscal conservative in his second reincarnation as governor?
There will be more fiscal conservatism in state houses and governor’s mansions.
Ben: What’s the state of municipal finances?
Chris Ryon: In the third quarter of 2010 receipts from all taxes were up about 3.9 percent from the prior year. That’s off of a very low base, but it’s still an increase. Receipts were probably running 4 percent under their 2008 highs. Early estimates for the fourth quarter of 2010 call for 6.9 percent year-over-year growth–in other words just 1 percent below the 2008 peak. So revenue is beginning to catch up with expenditures.
The Center on Budget and Policy Priorities issued a report examining the cuts that states have made to their budgets. The center found that 46 states have made cuts that hurt vulnerable residents.
Governor Chris Christie in New Jersey is one governor who has made tough choices. He’s been a big advocate of fiscal conservatism, but his popularity numbers have increased. His example gives many other politicians the political backbone–and political cover–to make these hard decisions, and they’re beginning to do just that.
Let’s look at the other big item that’s drawn attention: pension liabilities. The Pew Center on the States conducted a study called ‘The Trillion Dollar Gap.’ Based on 2008 data, the study estimated that on average, the states had funded 84 percent of their pension liabilities.
Of course there’s a broad range. New York’s pension liability was 107 percent funded, while Illinois has funded 54 percent of its pension liability. States aren’t faring too badly.
The Pew Center’s experts suggested that a funding level of 80 percent was adequate. States appear to be addressing this issue.
The markets tend to extrapolate short-term returns forever into the future. But we’re talking about 30- and 40-year liabilities–you have to examine long-term returns on these asset classes to get a full and measured picture of the liabilities.
Ben: So the tax increase we saw in Illinois was likely an isolated incident?
Chris Ryon: That was an extreme case. The headline was a 67 percent increase in state income taxes, which means the tax rate went from 3 percent to 5 percent. If you live in a state with 6 percent income tax, Illinois’ tax hike doesn’t seem that bad.
Most of the analyses I’ve read indicates that states are seeking to bolster revenue, but governors and legislators are also trying to balance budgets by reducing spending. States have cut almost 400,000 jobs since 2008. This little-known statistic demonstrates that states are making difficult financial decisions.
Ben: With yields still relatively tight, is there any value in taking on credit risk?
Chris Ryon: There are tremendous values in terms of taking credit risk. From 1991 to 2007, investors on average received 75 basis points of incremental income if they shifted from an AAA-rated general obligation bond to a BBB-rated revenue bond. And there was a trading range of about 25 basis points on either side of that.
Since 2007 that spread has increased to 250 basis points and the trading range has broadened to plus or minus 90 basis points.
There’s real value in prudently taking on credit risk right now, but you have to do your homework. The financial statements of most municipal issuers have become extraordinarily complex–that’s one of the reasons we focus on fundamental, bottom-up credit research.
Investors have to understand the risks associated with issuers’ extensive use of over-the-counter derivatives. Prior to the financial meltdown, municipalities would issue long-dated bonds to fund a project. That security would have a weekly or monthly put feature, and issuers would wrap it in insurance and sell it to a money market fund.
To offset that risk, issuers would enter an interest rate swap, because they would have all their risk at the front end of the curve where rates vary substantially. After the insurance companies blew themselves up, money market funds could own those securities. Consequently, the issuer would refund these securities with a standard municipal bond deal with varying maturities.
But because the swaps went out of the money, issuers didn’t unwind the swaps due to high termination fees. They had a ticking time bomb on their balance sheets. It isn’t a cash item because issuers haven’t had to post collateral, but if the liability gets too high or their credit rating drops, now they have to post collateral. That drains cash at a time they just can’t afford it.
You have to understand the types of complex risks issuers have on their balance sheets. When the market was 50 percent insured, municipal bonds were traded generically; investors wondered why they needed a professional portfolio manager. That’s not the case right now.
Prudently taking on credit risk can add a great deal of value to one’s returns, but you have to be able to manage that risk.
Ben: What’s your best piece of advice for investors?
Chris Ryon: The yield curve is extremely steep and should flatten, though we don’t know if that will be a result of rising short-term interest rates, falling long-term rates, or some combination of the two. Since the 1990s, the Fed has raised short-term rates during three distinct periods. That’s resulted in three separate scenarios for how the curve might be affected.The curve is steeper than it’s ever been. Investors should own short-, intermediate- and long-term bonds and have a longer time horizon.
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