Putnam Perspectives: Evolving municipal bond market makes compelling case for active management

8/3/2019 Putnam Perspectives: Evolving municipal bond market makes compelling case for active management

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Theclassicstrategicreasonstoownmunicipalbondsstillholdtrue:Theygenerally

havelowcorrelationstootherassetclassesandoerameaningultaxadvantage

toinvestors—eaturesthatareunlikelytochangeintheneartermHowever,themunicipalbondmarkethasexperiencedasignicantshitoverthepastseveralyea

throughthevirtualdemiseomunicipalbondinsuranceandthestressohighly

constrainedederalandstatebudgetsThispaperwillexaminehowthesechanges

themunicipalbondmarkethavehadanimpactontheevaluationomunicipalsecu

ties,whetheritmakessensetoinvestinmunicipalbondstoday,andhowinvestors

mightneedtochangethewaytheyimplementtheirinvestmentstrategiesasaresu

Figure 1. Municipal bonds are not highly correlated with other asset classes

Municipal bond correlations versus other assets (12/31/11)

0.03

0.09

0.30

0.59

0.69AA U.S. corporate bonds

10-year U.S. Treasuries

U.S. high-yield bonds

S&P 500 Index

1- to 3-month T-bills

Sources:BarclaysCapitalBondindices,Standard&Poor’s

Stacking up yesterday versus today

Incomparingthemunicipalbondmarketromyearsagowithtoday’smarket,manycharacteristicsremainconsistentAdecadeago,thetopvestateissuerswe

Caliornia,Florida,Illinois,NewYork,andTexasandrepresentedroughlyothe

market;thisisstilltruetodayInact,nineothetoptenissuersromwerestill

thatlistin,andcontinuedtoconstituteapproximatelyothemarket

Amongthechangeshasbeenageneraltrendawayromlocalgeneralobligationiss

ancetowardissuesbackedbyspecialtaxesorassessmentsInmanyinstances,the

issuanceogeneralobligationdebtrequiresvoterapprovalOnewaytoavoidgoing

throughthatprocessistoissuespecialtax/assessmentdebt,whichmayrequireno

• Municipal bonds remain

strategically importantinvestments with signicant

tax advantages and generally

low correlations to other

asset classes over time.

• The near elimination o bond

insurance has dramatically

changed the municipal

ratings landscape.

• Municipal bond undamentals

are helped today by low

deaults and attractive

spreads over Treasuries.

• Actively managed unds

driven by undamental

research can help add

broad diversication and

mitigate risk.

FOR INVESTMENT

PROFESSIONAL USE ONLY.

Not for public distribution

February 2012 » Putnam Perspective

Evolving municipal bond

market makes compelling

case for active management

Thalia Meehan, CFA

Portfolio Manager

Paul M. Drury, CFA

Portfolio Manager

Susan A. McCormack,

Portfolio Manager

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FEBRUARY 2012 | Evolving municipal bond market makes compelling case for active management

FOR INVESTMENT PROFESSIONAL USE ONLY.

voteoravotebyamorelimitedgroupotaxpayersThis

shitcouldalsobeconsideredanindicationoinvestor

preerenceor“clean”owsthatothergovernmental

entitiesarenotallowedtoaccess,aswellasgenerally

reliablecovenantssupportedbyruleolaw

Figure 3. An increase in issues backed by

special taxes/assessments refects a tougher

budgetary environment

Distribution of municipal sectors

Sector distribution (%) 12/31/01 12/31/11 Change

State general obligation 15 17 +2

Transportation 16 15 -1

Local general obligation 20 13 -7

Special tax 3 11 +8

Water & sewer 8 9 +1

Hospital 9 9 -

Leasing 5 8 +3

Education 5 7 +2

Power 10 7 -3

Other (< 3%) 9 5 -4

100 100

Source:BarclaysCapitalMunicipalBondIndex.

However,thekeyshitinthemarkethasbeenthe

considerablechangeincreditqualitydistribution

AsoDecember,,theAAAsegmentothe

municipalbondmarketrepresentedapproximately

othemarket;thatgurehasdeclinedtoonly

today(Figure) ! Thismajorchangecanbeattributed

totwoactors:mostimportant,thenearelimination

obondinsuranceorthemunicipalmarket,butalso

thedownwardmigrationomunicipalratingsinthe

wakeosignicantscalstressatboththeederaland

statelevelsAtitspeakoverthepastyears,bond

insurancewasusedinomunicipalsecurities

issuedin,withthebulkotheunderlyingsecurities

carryinginsuranceratedsingleA(Asseeninthe

creditqualitychartoFigure,ibondinsurance

hadbeenstrippedout,themunicipalbonduniverse

wouldhavehadasignicantlyhigherconcentrationo

A-ratedsecurities,ratherthanaAAA-ratedsegment

representingmorethanothemarket)

In,usageobondinsurancedeclinedtoamere

(Figure)Thisprecipitousdropinbondinsurancebegan

inastheinsurersexperiencedmountinglosses

associatedwithguaranteesonsubprimemortgage-

backeddebtAsaresult,insurersweredowngradedand

losttheirtopratingsorenteredbankruptcyWithoutthe

abilitytoachieveatopratingandthereorelowertheir

debtcosts,mostmunicipalbondissuerslosttheincen-

tivetopayortheadditionalcreditenhancement

Thedeclineoinsuranceisonlyoneotheactors

contributingtothedownwardtrendincreditquality

Moody’sInvestorServicereportedthedowngrade-

to-upgraderatioorthethirdquarteroat

approximatelytoThisisthehighestratiosincethe

BarclaysCapital,BarclaysCapitalMunicipalBondIndex

Figure 2. The top nine issuing states and Puerto Rico have remained consistent

By market value ($M)

0

50,000

100,000

150,000

200,000

12/31/1112/31/01

WashingtonPennsylvaniaPuerto RicoNew JerseyMassachusettsIllinoisFloridaTexasNew YorkCalifornia

Source:BarclaysCapitalMunicipalBondIndex.






beginningothenancialcrisisin;however,the

absolutenumberodowngradesinthethirdquarter

()waslessthanthepeakexperiencedintheourth

quartero()Whiledowngradesmaybehigh

byhistoricalstandards,keepinmindthattheyrepre-

sentasmallportionotheMoody’s-ratedpublicnance

universeinthethirdquarter:lessthan(Figure)

Moody’sInvestorService,U.S. Public Finance: Third Quarter Sets

New Peak for Ratio of Downgrades to Upgrades,November,

Value to be found

Giventhesestructuralchanges,investorsmaybe

wonderingwhethermunicipalbondscontinuetowarrant

anallocationWebelievemunicipalbondinvestmentsare

potentiallyquiteattractive:Deaultshaveremainedlow,

contrarytooverblownpredictionsinthemedia;spreads

areattractiveonahistoricalbasis;andmuni/Treasury

ratiosarestillabovehistoricalaverages

Deaultsinthemunicipalbondmarketaregenerally

misunderstoodWhiledeaultsdohappen,theyoccur

witharlessrequencythaninthecorporatebond

Figure 4. The decline o bond insurance has sharply reduced the availability o AAA bonds

Credit quality composition

12/31/01 12/31/11

BBB

A

AA

AAA

Source:BarclaysCapitalMunicipalBondIndex

Figure 5. Bond insurance as a percentage o total municipal new issuance

0

10

20

30

40

50

60%

20112010200920082007200620052004200320022001

Source:The Bond Buyer,.






market,andmoreotenthannot,theyareconnedto

particularsectorsothemarket,typicallyinlanddevel-

opmentdealsorunratedsecuritiesWebelievebond

insurancehadverylittleimpactonhistoricaldeault

statistics;theinsurersgenerallyprovidedcreditenhance-

mentorsingle-Adealsandnotorthoseatthelowend

otheratingspectrum,whicharemorepronetodeault

Whendeaultsoccur,theytendtocaptureheadlines

Recently,AmericanAirlines’s$billioninmunicipaldebt

aswellasapproximately$billionintobaccosettlement-

backeddebtwereaddedtodeaultstatisticsalthough

nopaymentshavebeenmissed;these“deaults”were

duetotheparticularsothecalculationmethodology

thathasbeenusedormanyyearsbytheDistressed Debt

Securities Newsletter Themethodologyincludestech-

nicaldeaultsaswellasbankruptciesandotherormso

non-monetarydeault,eg,accessingreserveunds,asis

beingdoneinthecaseothetobaccobonds

JeersonCounty,Alabama—anotherheadline-grabbing

deaultin—hadbeeninnegotiationsorseveral

yearstryingtoworkthroughitsscalissues;however,the

countyrecentlyoptedtoleorbankruptcyandbecame

thelargestmunicipalbankruptcyinUShistoryat$

billionThecounty’sgeneralobligationdebtoabout$

billionwasalsorecentlyaddedtothedeaultstatistics

Whilemunicipaldeaultshavetickeduprecently,itis

importanttonotethatthepredictedmassivenumber

odeaultshasnotmaterializedNearlyoneyearago,

onewell-knownanalystpredictedtosizeable

deaults,totalinghundredsobillionsodollarsThose

earsareprovingtobeunoundedInact,munideaults

areonlyminimallyhigherthantheir-yearpeakin

andareoutpacedhistoricallyateveryratinglevel

bycorporatebonddeaults(Figure)Thisisnottosay

thattherewillnotbeuturedeaultsinthemunicipal

market;therewillbeButtheundamentalbudgetstress

attheheartothecurrentstruggleswillslowlyeaseas

thescalmeasuresbeingputintoactionbythestates

andmunicipalitiesbegintotakeeectandastheUS

economycontinuestoimprove

Moody’sInvestorService,U.S. Municipal Bond Defaults and

Recoveries, 1970-2009, February

Muni defaults are only minimally higher than their 20-year peak

in 1991 and are outpaced historically at every rating level by

corporate bond defaults.

Figure 6. Despite the recent uptick, deaults are low as a percentage o the total market

Municipal defaults since 1990

2011201020092008200720062005200420032002200120001999199819971996199519941993199219911990

Sources:Distressed Debt Securities Newsletter,Putnam,aso//Municipalmarketisestimatedat$trillion






Figure 7. At every credit rating, corporate deaults

outpace those in the muni market

Moody’s 5-year average cumulative default rates

Rating Municipal Corporate

All rated 0.05% 7.14%

Aa 0.01 0.23

A 0.01 0.72

Baa 0.08 1.93

Ba 1.57 10.40

B 11.73 25.90

Investment grade 0.03 0.97

Speculative grade 3.43 21.36

Source:Moody’sInvestorService,U.S. Municipal Bond Defaults and


Itisworthnotingthatrecoveriesinthemunicipalmarket

alsorunhigherthanistypicalinthecorporatecreditmarket,thoughtherangeisquitewideFortheMoody’s-

rateddeaultsoccurringromto,theaverage

recoveryratewasapproximately,whiletherange

wasanywhererombelowtoForexample,

theOrangeCounty,Caliorniabankruptcywasthe

largestmunicipalbankruptcyinhistoryatthattime,but

whatewinvestorsrecallisthatallprincipalandinterest

paymentsweremadeComparethiswiththeaverage

corporaterecoveryrateoromtoThat

isroughlyadierence;recoveringaquartermorein

valueisquitemeaningul

Moody’sInvestorService,U.S. Municipal Bond Defaults and


Moody’sInvestorService,Corporate Default and Recovery Rates,

1920-2009,February

Withthatbackdropinmind,spreadsoncredittiers

belowAAAlookattractivecomparedwiththeirhistorical

averagesThepresenceobondinsuranceprimarily

inuencedtheAAAcreditsector,soocusingonAA

andbelowisabettermeasureohistoricalspreadlevels

Currentspreadsrangerombasispointstoover

basispointsorsecuritiesratedAAtoBBBversustheir

historicalaveragesoverthepastyears (Figure)

IthevolatiletimeperiodoOctoberthrough

Decemberisexcluded,thecomparisonocurrent

spreadstoa“normalized”timeperiod(January,,

toSeptember,)illustratesthattoday’sspreads

are(AA)to(BBB)basispointswiderthanwould

typicallybeexpectedWithspreadswiderthanhistorical

levelsanddeaultsremaininglow,theinvestorisgetting

paidmorethanaverageorrisksthataregenerallyinline

withhistoricalnorms

Anothermeasureotheattractivenessomunicipal

securitiesisthecomparisonwithUSTreasurysecuri-

ties,generallyreerredtoasthemuni/Treasuryratio

Typically,theAAA-ratedmunicipalyieldiscompared

withtheyieldoasimilardurationUSTreasurysecurity

Currentmuni/Treasuryratiosor-,-,and-year

maturitiesareatlevelsapproximatelyonestandard

deviationawayromtheirlong-termaveragesInpart,

thisistheresultotheabsolutelowleveloratesaswell

asthegenerallywiderspreadlevelsomunicipalbonds

Buttheresultsaresignicant:Simplystated,investors

areabletobuy-yearAAAmunicipalsecuritiesthat

out-yielda-yearUSTreasurybondonapretaxbasis

Atertaxes,investorsurtherbenetromthetax-ree

incomeoeredbymunicipalbonds

PutnamInvestments

With spreads wider than historical levels and defaults remaining low, the

investor is getting paid more than average for risks that are generally in

line with historical norms.






Figure 8. Spreads remain elevated at higher credit ratings

Historical municipal spreads (bps), 1/30/99–1/17/12

BBBA

AA

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source:PutnamInvestments,aso//

Implementing an investment strategy

Tosummarizethemunicipalbondlandscape:

•Creditundamentalsareweatheringthestormmuch

betterthananticipated

•Deaultsremainlow

•Creditspreadsandmuni/Treasuryratiosareattractive

relativetohistoricallevels

•Researchandactivemanagementareevenmoreimpor-

tantaterthevirtualdisappearanceobondinsurance

Butwhatisthebestwaytoimplementamunicipalbond

strategygiventhechangesinthemarketplaceandthe

currentenvironment?Aportoliooladderedindividual

bondsorsharesoamutualund?Investmentgradeor

highyield?Nationalorstate-specic?Thereareseveral

waystoimplementamunicipalstrategy,andtheprimary

considerationmustalwayshingeonwhatissuitableor

theindividualinvestorAssumingthatrisktolerance,timehorizon,etc,isdetermined,oneormoreothemethodso

implementingamunicipalstrategymaybeappropriate

Inmanycases,amunicipalbondinvestmentstrategy

willconsistoaconcentratednumberoindividual

bondsladderedbymaturitydateWithoutbeingableto

relyonbondinsurancetoprovideaguaranteeoprin-

cipalandinterestpayments,theresearchandreview

oanissuerandtheprovisionsothesecurityaremore

importantthaneverbeoreThereareapproximately

,issuersinthemunicipalmarket,andtheyarear

romuniorm,witheachhavingitsownspecicnuances

relatingtothebondcovenantsorsomeaspectothat

particularbondstructureUnortunately,manyadvisors

andinvestorsmaynotbeawareothebestwaytond

thenecessaryinormationonthebondormaynothave

thetimeorexpertisetodothethoroughreviewneeded

toavoidpotentialpitallsRelyingonrating-agency

designationsprovidessomerelativesenseoquality,

butthatrststepisnotasoundcreditstrategyinando

itseland,webelieve,isnotanoptimalwaytoavoidthe

potentiallylargelossesaninvestorcouldaceinaport-

oliowithonlyaewindividualbondholdings

Investinginundsisagoodwaytoleveragevastly

greaterdiversicationbenetsaswellasproes-

sionalundmanagementcoupledwiththeexpertise

oaseasonedresearchteamFundamentalresearch,

whenproperlyimplemented,canhelpmitigaterisk

byidentiyingpotentiallydeterioratingcreditsinthe

municipalbondmarket,whichmayeitherbesoldrom

theportoliooravoidedaltogetherThiscapacityiso

heightenedimportancetodaywiththearlesspromi-

nentroleobondinsuranceandissuerscontinuingto

worktheirwaythroughthenancialcrisis






Anactivelymanagedundalsoprovidesavehiclethat

maytradeopportunistically,typicallyatlowercostsdue

tomoreefcientblocktradingMoreover,themanager

mayemploystrategiessuchassectororqualityrota-

tion,andmoreexibleyieldcurvepositioning,botho

whicharedifcultinotimpossibleorinvestorsbuilding

theirownladderedportoliosAdditionally,investorsareabletoredeemaportionorallotheirinvestmentat

anytime,whileindividualbondscanbedifculttoliqui-

dateFundsalsotypicallypayregular,monthlyincome,

althoughthatincometypicallyuctuatesandisnotxed

Thatbeingsaid,aundisamoretransparentvehicle,

withmarketmovesreectedinthecalculationonet

assetvalueonadailybasisLastly,itisworthnotingthat

eesmaypotentiallybehigherinamutualundthanina

ladderedportolioduetogreateradministrationcosts

Giventhemanybenetsousingamutualundtoaccess

themunicipalbondmarket,investorsusingaportolio

oladderedbondsmayconsideraddingaundasa

complementtotheirexistingholdingsForexample,

itheinvestorownsprimarilyAA-ratedbonds,itmay

makesensetoinvesttheproceedsothenextmaturing

individualbondintoatax-reehigh-yieldund,which

couldpotentiallyaddqualitydiversicationaswellas

increasedyieldAlternatively,theinvestormayown

severalstate-specicbondsAddinganinvestmentina

Shareprice,principalvalue,andreturnwillvary,andtheremaybe

againoralosswhensharesaresoldInaddition,reviewtheund

prospectusascertainundsmayenorceshort-termtradingpolicies

nationalmunicipalbondundcandramaticallybroaden

theinvestor’sdiversicationInsum,introducingactively

managedmunicipalbondportolioscouldaddgreater

diversicationandmorethoroughriskmitigation,and

provideabroaderopportunitysetorincreasingvalue

Whilethemunicipalmarkethasevolvedinrecentyears,

municipalbondsremainstrategicallyimportantinvest-

mentswithsignicanttaxadvantagesandgenerallylow

correlationstootherassetclassesovertimeCurrently,

webelievethismaybeanattractiveentrypointor

municipalbondinvestors,andonewaytodothatisto

useactivelymanagedundsinplaceoorasacomple-

menttoindividualbondsRelyingonproessional

managersanddeepresearchteamstotakeadvantage

otimelyopportunitiesprovidesnotonlythepotential

oradditionalreturnorinvestorsbutbroaderdiversi-

cationandriskmitigationinamarketenvironmentthat

ismuchmorechallengingtonavigatetodaythanitwas

onlytenyearsago

Figure 9. Long-dated munis are out-yielding comparable Treasuries even without the tax advantage

Muni/Treasury

ratios Averages Standard deviation

Jan. 20, 2012 Since 1990 Since 1998 Since 2000 Since 1990 Since 1998 Since 2000

5 years 92% 80% 83% 84% 12% 14% 15%

10 years 90 83 88 89 9 10 11

30 years 107 91 98 99 12 12 13

Sources:MMD,Bloomberg,PutnamInvestments,aso//

Fundamental research, when properly implemented, can help mitigate

risk by identifying potentially deteriorating credits in the municipal bond

market, which may either be sold from the portfolio or avoided altogether.




273018 2/12

Thalia Meehan is a Portolio Manager within Putnam’s

Tax Exempt Fixed Income Group. She earned a B.A.

rom Williams College, is a CFA charterholder, and has

worked in the investment industry since 1983. She is a

member o the Boston Security Analysts Society and

the Society o Municipal Analysts.

Paul Drury is a Portolio Manager within Putnam’s Tax

Exempt Fixed Income Group. He earned a B.A. rom

Sufolk University, is a CFA charterholder, and has

worked in the investment industry since 1989.

Susan McCormack is a Portolio Manager within

Putnam’s Tax Exempt Fixed Income Group. She earned

a B.A. rom Dartmouth College and an M.B.A. rom

Stanord University, is a CFA charterholder, and has

worked in the investment industry since 1986.

The views and opinions expressed are those of the authors, are subject to change with market conditions, and are not

meant as investment advice. Companies and municipalities referenced may or may not be Putnam fund holdings.

Consider these risks before investing:Capitalgains,iany,aretaxableorederaland,inmostcases,statepurposes

Forsomeinvestors,investmentincomemaybesubjecttotheederalalternativeminimumtaxIncomeromederally

exemptundsmaybesubjecttostateandlocaltaxesFundsthatinvestinbondsaresubjecttocertainrisksincluding

interest-raterisk,creditrisk,andinationriskAsinterestratesrise,thepricesobondsallLong-termbondsaremore

exposedtointerest-rateriskthanshort-termbondsUnlikebonds,bondundshaveongoingeesandexpenses

Your clients should carefully consider the investment objectives, risks, charges, and expenses of a fund

before investing. For a prospectus or summary prospectus containing this and other information for any

Putnam fund or product, call Putnam Dealer Marketing Services at 1-800-354-4000. Your clients should

read the prospectus carefully before investing.

Putnam Perspectives: Evolving municipal bond market makes compelling case for active management

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