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Bryan J. Bailey, CFA
Portfolio Manager
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Waddell & Reed Advisors Municipal Bond Fund Perspectives - September 2011
For municipal bond investors, it has been a tumultuous year. After taking a beating early in the year amid a high-profile (and incorrect) forecast of a virtual muni marketmeltdown, municipal investors were able to find stability only to be shaken again — this time amid uncertainty on how a downgrade of the nation’s sovereign credit rating would ripple through the market. This fall, federal spending will again be in the spotlight as a select bi-partisan Congressional committee works on a plan to cut more than $1 trillion over the next decade and perhaps again raise concerns about the availability of federal funds for local governments.
Should municipal bond investors be concerned?
A tale … full of sound and fury
Although economic uncertainty has left investors in all asset classes a bit jittery, for municipal bond markets, it appears investors may have spent the past year facing a lot of sound and fury, the significance of which is difficult to determine.
The turmoil was initially stoked in late 2010 when financial analyst Meredith Whitney predicted as many as 100 major muni-bond defaults totaling $100 billion or more would happen in 2011 as local governments wrestled with financial headwinds. While the comments roiled the municipal bond market it turned out Whitney, whose reputation was built on prescient comments about the banking sector prior to the 2008 financial crisis, was far off the mark with her forecast. However, through Aug. 12, defaults this year have totaled a modest $757.8 million1 — or 0.7 percent of what Whitney projected for the year. To put the disparity in the forecast in an even sharper perspective, keep in mind that Whitney’s prediction called for the market to average more than twice that figure (a total of nearly $2 billion) in new defaults each week for the entire year. Looking back from a vantage point in the early autumn of 2011, it is almost surprising that a prediction so clearly wide of the mark would have an impact on the markets.
In fact, according to a July Bloomberg report, through the first half of this year defaults were down 60 percent from the same period in 2010 when there were 60 defaults totaling $2.29 billion and even further below the first half of 2009 when there were 144 defaults totaling $4.98 billion. Most of this year’s issuers that have encountered difficulty have been small ones that draw their revenue from special-assessment districts, housing developments and hospital complexes, not general tax revenues. Going forward, we do not expect defaults will break historical norms for the rest of the year and expect virtually all of the defaults to occur in the high-yield space. In fact, according to a Moody’s Investor Service study of the period from 1970 through 2009, there were only 54 rated defaults among 18,400 municipal issuers rated by Moody’s over the 39-year period, equating to a 0.09 percent 10-year average cumulative default rate.2
In the wake of the overblown default fears, municipal markets were once again faced with another potential headwind — this time by political wrangling over the debt ceiling that continued deep into the eleventh hour. While the sometimes over-the-top rhetoric of the debate appears to have had a far-reaching impact— there are indications it ruffled everything from consumer confidence to stock prices — experienced municipal bond investors recognized that the fear that federal funding cuts might lead to increased levels of municipal debt defaults was once again overblown in the markets. And while Standard & Poor’s did end up downgrading the federal credit rating and, in turn, later lowered the ratings on some other government issues because of their close tie to the federal government, we believe the $3 trillion municipal bond market remains stable and highly credit worthy.
Focusing on the facts
One benefit of this year’s turmoil is that it has clearly illustrated why it is important for investors to fully understand what risks they are taking with their money. For the individual investor, that understanding can provide important stability during times when the broader markets are reacting sharply to the news of the day. We believe it is important for investors to not get caught up in hype and let the media influence their investment decisions.
In the municipal bond market, it is important to recognize that defaults are exceptionally rare. There are reasons for that. State and local governments are not corporations and cannot “go out of business.” In fact, by law states cannot file for bankruptcy and many states have laws that prevent municipalities from filing. Even without the legal constraints, a municipal default is an exceptionally expensive proposition to the point that it is virtually never a viable solution because it is almost assured to prevent the municipality from future borrowing and access to the capital markets. Municipalities are created to provide services and are not profit-driven. In situations where funding falls below local budget projections, the municipalities will generally impose austerity measures by reducing services or other costs — such as employee wages or benefits — or raise income through increased taxes, fees or other service charges.
It is also important to recognize that, although federal lawmakers may be headed back into a spending battle, the states are far better equipped — and more experienced — at balancing their books after going through the recent recession. Unlike their federal counterparts, state lawmakers cannot engage in deficit spending. As a result, states have already made sometimes painful decisions to control their costs. Additionally, it appears that states may be in better shape financially than they were a year ago. In July, the Nelson A. Rockefeller Institute of Government at the State University of New York at Albany issued a report saying state tax revenue was up an average of 9.3 percent during the first quarter and continued to run ahead of year-ago levels into the second quarter.
Looking ahead
We don’t expect any significant change to the current low levels of default activity going forward. Budget gaps at the state and local levels have been addressed and, we believe, when combined with reports of tax revenues above last year’s levels, the result is that states are generally in better shape financially than they were a year ago. Although the federal spending situation remains murky, we do not believe state and local governments are heavily reliant on federal funds to make debt payments. We would expect state and local governments to view any increased funding from the federal level as an unexpected surprise and not critical to their financial picture in most cases.
While budget tightening at the state and local level should not have an impact on debt payments, it is, however, having an impact on new debt issuance. We expect investor demand for municipal bonds will continue to outpace supply through the end of the year as we continue to expect a light calendar for new issues.
Municipal bond fund investing
For investors looking to participate in the public finance market, municipal bond funds can offer numerous benefits when compared against investing in individual bonds, most notably professional managers who carefully monitor the Fund and are able to potentially capitalize on opportunities and mitigate risks before they might even become apparent to many holders of individual bonds. The Waddell & Reed Advisors Funds team continually monitors the portfolio which is designed to allow the team to be aware of any possible credit deterioration far in advance of an individual investor.
Because funds are considered institutional buyers, pricing can be much more favorable for a fund than for an individual bond investor and the Fund provides the investor far more liquidity than if they hold an individual issue. The Fund is marked to market on a daily basis and provides daily liquidity to its investors. Individual debt instruments are not always easily liquidated and trading individual bonds can be expensive.
Perhaps most important is the diversification of a bond fund. Unlike an individual bond purchase, which ties an investor to one credit exposure, one spot on the yield curve and the potential for greater loss if that one issue would happen to default, bond funds can include a mix of issues with a wide range of maturities.
Diversification is one of the strongest features of the Waddell & Reed Advisors Municipal Bond Fund, though diversification alone cannot ensure a profit or protect against loss. The Fund holds a mix of investment-grade bonds, primarily revenue bonds. Unlike general obligation bonds, revenue bonds are backed by a specific revenue source. Waddell & Reed Advisors’ revenue bond holdings are widely diversified across all sectors of the municipal bond market as well as geographically.
The Fund has a range of maturities from one to 35 years. Because of the way the Fund is structured, its average maturity is 14 years, but its option adjusted duration (which is the Fund’s sensitivity to interest rate changes) is approximately 8.66 years, or similar to what an investor would see on a 10-year bond.
However, while the duration is similar to a 10-year bond, its taxable-equivalent yield can be higher — and in some cases significantly higher — depending on the investor’s tax bracket. For example, as of 8/31/11, the Fund’s annualized 30-day SEC subsidized yield was 3.07 percent. Tax adjusted to a to a taxable rate for an investor in the 35 percent tax bracket, the figure equates to a taxable-equivalent yield of 4.72 percent compared with a yield of approximately 3.72 percent on a corporate A-rated bond.
The Fund is managed for low levels of total return volatility. On a risk-return basis, it can provide a degree of protection on the downside while participating on the upside. The Fund has historically had a lower standard deviation and the Fund has historically had a low turnover ratio.
Although the media has offered a bleaker outlook on the state of the municipal markets, this seems to us to be nothing more than overblown headlines. As of the beginning of the third quarter the public finance markets continue to chug along despite some of the economic headwinds currently facing the country.
Fund Performance
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As of 08/31/2011
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Quotron
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Inception Date
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1-Year
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3-Year
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5-Year
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10-Year
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Life
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Expense Ratio
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Expense w/ Waiver
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Class A (Load)
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UNMBX
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11/05/76
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-1.30%
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4.41%
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4.09%
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3.84%
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5.82%
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0.95%
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0.95%
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S&P Investortools Main Muni Bond
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—
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—
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3.70%
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5.35%
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4.64%
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4.99%
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—
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—
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—
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Lipper General Municipal Debt
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—
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—
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2.73%
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4.08%
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3.37%
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3.89%
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—
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—
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—
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Annualized 30-Day SEC Yieldas of 8/31/2011 Subsidized 3.07% Unsubsidized 3.03%
1Bank of America/Merrill Lynch report in Barron’s article Aug. 29, 2011
2U.S. Municipal Bond Defaults and Recoveries, 1970-2009, Moody’s Investor Services, Feb. 11, 2010
Data quoted is past performance and current performance may be lower or higher. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Please visit www.waddell.com for the most recent month-end performance.
Performance at net asset value (NAV) does not include the effect of sales charges. Class A share performance, including sales charges, reflects the maximum applicable front-end sales load.
Index Description: Standard & Poor‘s/Investortools Municipal Bond is an unmanaged index comprised of bonds held by managed municipal bond fund customers of Standard & Poor's Securities Pricing, Inc. that are priced daily. It is not possible to invest directly in an index.
Consider all factors. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in the fund’s prospectus. The Fund may include a significant portion of its investments that will pay interest that is taxable under the Alternative Minimum Tax (AMT). Not all funds or fund classes may be offered at all broker/dealers.
30-Day SEC Yield represents hypothetical net investment income earned by a fund over a 30-day period, expressed as an annual percentage rate based on the fund's share price at the end of the 30-day period. This hypothetical income will differ (at times, significantly) from the fund's actual experience; as a result, income distributions from the fund may be higher or lower than implied by the SEC yield.
Unsubsidized yields reflect what the yield would have been without the effect of reimbursements and waivers. The adviser and its affiliates have or may voluntarily waive a portion of their fees (including, but not limited to, distribution and service (12b-1) fees) and reimburse certain expenses. There is no guarantee that the fund will avoid a negative yield. Such undertaking may be amended or withdrawn at any time.
The opinions expressed in this commentary are those of the Fund's manager and are current through June 30, 2011. The manager's views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results. As with any mutual fund, the value of the Fund’s shares will change, and it is possible to lose money on your investment.
Consider all factors. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interestrates rise. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. The Fund may include a significant portion of its investments that will pay interest that is taxable under the Alternative Minimum Tax (AMT). An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in the Fund’s prospectus.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit us online at www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.