Separating the 'news' from the headlines: Muni market downgrades
- The downgrade of Puerto Rico's credit quality was not surprising.
- Most downgrades are expected well before they actually happen.
- Credit selection remains critical to our strategy.
Michael J. Walls
At the most basic level, the risks generally faced by fixed income investing fall into two categories: credit risk, or the risk that an issuer will default on their obligations; or interest rate risk, the risk that interest rates will rise, causing bond prices to potentially decline. Recent years, however, have seen the market regularly confront another type of risk, known as headline risk, which is created as investors react to potentially negative headlines. Sometimes it is merited, but often times, in our experience, we believe it is not. This was recently illustrated to a degree by the recent downgrades of Puerto Rico’s general obligation (GO) debt and related bonds by Standard & Poor’s and Moody’s Investor Service
Michael Walls, portfolio manager of the Waddell & Reed Advisors Municipal High Income Fund, takes a look at the issue.
Down in Puerto Rico
The Standard & Poor’s (S&P) downgrade of Puerto Rico’s GO bonds, which was followed by Moody’s and Fitch, made a lot of headlines. To a point, it is understandable. Puerto Rico enjoys a unique status as a U.S. territory and, while it is not a state, its bonds enjoy local, state and federal tax exemptions. The commonwealth is the fourth largest issuer of munis, (trailing only California, Illinois and New York, according to Barclays), and its bonds have paid an attractive yield. About 80% of municipal bond funds have some amount of Puerto Rican debt in their portfolios, according to Morningstar.
For those who regularly trade in the municipal bond market, the downgrade was far from unexpected. The general consensus among many analysts and municipal bond portfolio managers (and as readily found online) was that the downgrade was long overdue. The reason why Puerto Rican debt offers some of the highest yields in the muni sector correlates directly with the market’s understanding of the credit quality. That view is supported by the fact that the market did not see a mass selling in the first trading session after the S&P announcement. That is not to say that there was no impact on the muni market. Puerto Rican bond prices did slip and mutual funds with substantial exposure did trim their positions, but there was no exodus and trading volume on Puerto Rican debt was thin.
In cases such as this, we believe it is important for mutual bond fund investors to understand that while the media may focus much attention on these and similar events, they are often well-known and broadly expected by the municipal bond market before they occur. Any municipal bond fund managers who were surprised by this development, in our view, were not paying attention to the market. Although ratings downgrades are designed to offer guidance about an issuer’s future ability to service its debt, the downgrades were based on information that was already broadly known such as tax and fee revenues or government policy changes. As a result, a ratings change is, in many ways, often an afterthe- fact event. This is not unlike what we have seen in Detroit and a handful of other municipalities in the U.S.
Our Puerto Rican holdings align with our general fund strategy of favoring revenue bonds over GOs that we feel do not provide sufficient return to offset potential risk. The Waddell & Reed Advisors Municipal High Income Fund’s holdings of Puerto Rican debt are almost exclusively revenue bonds , which were not the primary focus of the recent downgrade. These bonds continue to trade around the same levels we saw prior to the downgrade and, in the immediate aftermath of the downgrade, we saw more interested buyers than sellers in the market.
Throughout 2013, we tactically increased our Puerto Rican debt holdings to take advantage of dislocation that depressed the prices – in some cases 60 cents on the dollar – for what we believed to be attractive yields. As of Jan. 31, 2014, Puerto Rican debt was 5.1% of the Fund, up from 3.1% of the Fund a year earlier. Our allocations are presently in line with the benchmark Barclays High Yield Muni Index.
As always, we will continue to closely monitor the situation and may adjust our positions depending on what we see in terms of supply and demand. Headlines such as these have the potential to create choppy waters, however we believe funds that focus on quality credits can provide high net worth investors with attractive levels of income over the long term. Overall, we will continue to purchase deals we feel offer above-market yields based on the underlying credit fundamentals of the projects or municipalities. We place a high value on credit selection.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current as of Feb. 19, 2014 and are subject to change due to market conditions or other factors.
The Barclays High Yield Municipal Index is an unmanaged index made up of bonds that are non-investment grade, unrated, or rated below Ba1 by Moody’s Investors Service with a remaining maturity of at least on year. It is not possible to invest directly in an index.
Risk Factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. 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. The lower-rated securities in which the Fund may invest may carry a greater risk of nonpayment of interest or principal than higherrated bonds. 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. The Fund may include a significant portion of its investments that will pay interest that is taxable under the Alternative Minimum Tax (AMT). These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.