Sean P. Simko of SEI’s Fixed Income Portfolio Management team writes in a recent SEI commentary: “The Municipal Market Sends a Message: Know What You Own! “
The municipal market continues to be the focus of negative press, with the most recent example coming from the CBS TV show 60 Minutes. There are a lot of numbers being thrown around regarding defaults, bankruptcies, tax revenues and funding needs. Some of those numbers may be accurate, while others can be a bit misleading. This scenario highlights the importance of knowing what you own.
The municipal market is a $2.8 trillion market. As with any market, you have a variety of issuers commanding varying levels of credit ratings ranging from high-quality to junk. Yes, there are certain regions, states and municipalities that are under tremendous pressure from funding gaps driven by softer-than-expected tax revenues. The list of names should not be surprising; California, Arizona, Nevada, Illinois and Rhode Island are a few of the states that have held positions in this category for quite some time. However, there are also regions, states and municipalities that are rock-solid. The challenge for investors is to separate the strong from the weak.
Consider it this way: There are more than 50,000 municipal issuers within the United States.(1) If there are 100 municipal defaults in the marketplace, it would equate to a default rate of less than one quarter of a percent. While the sector is still subject to credit pressures, we feel that the recent headlines have overblown the situation. The increased volatility is more liquidity- and supply-driven than credit-driven. With the termination of the Build America Bonds (BAB) program, state funding costs will go up. This will add pressure to spreads, as will the onslaught of tax-exempt issuance in lieu of the BAB program. The situation around state and municipal credit remains elevated, but has not significantly changed. Therefore, we are not expecting a sharp increase in defaults or bankruptcies. Municipal market investors may be faced with bankruptcies and/or defaults in 2011 from lower-quality issuers, but these problems do not mean there will be widespread losses that extend to higher-quality issuers.
A more realistic problem than widespread default is the potential for panic within the market that could create forced selling by fund managers that locks in losses. Investors who own municipal securities within a separately managed account do not have to worry about forced selling caused by other investors, as monies in a separate account are not comingled. Mark to market (2) is also not an issue if the strategy experiences little to no turnover. Ladder and barbell strategies, (3) for example, are designed to weather volatile or troubled markets over a long-term time horizon.
Municipal-market concerns are not going away any time soon, and are likely to remain in the headlines for years to come. It is important to keep the headlines in perspective, separating reality from the possibility (or probability) of a doomsday scenario. That said, there is no reason to panic if the proper due diligence (including a full credit review) is executed. The expectation over the near term is that the vast majority of municipal issuers will make timely debt-service payments, consistent with the low-default experience seen in this sector over the last sixty years. However, the unprecedented stress on this sector is likely to produce defaults at a higher rate than we have seen in the past. We expect to mitigate this risk in our portfolios* by remaining highly diversified through the acquisition of high-grade credit within sectors which we feel will provide less volatility.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only.
There are risks involved with investing, including loss of principal. No mention of particular securities should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities.
SEI Investments Management Corporation or its employees may sometimes hold positions in the securities discussed here.
SEI Fixed Income Portfolio Management is a unit of SEI Investments Management Corporation, which serves as the investment advisor.
*SEI Fixed Income Portfolio Management manages fixed-income strategies for SEI’s Managed Account Program (MAP).
1 Source: U.S. Securities and Exchange Commission is also not an issue if the strategy experiences little to no turnover. Ladder and barbell
2 Mark-to-market (MTM) accounting attempts to assign a current market value to an asset, usually on a daily basis. This measurement can cause issues, however, if it does not provide a realistic appraisal of the asset .
3 Ladder and barbell (and also bullet) strategies are designed to balance the effects of interest-rate fluctuations in bond portfolios, mainly through a calculated structuring of maturity dates.