Municipal Market Update:
Opportunities Exist
November 17, 2009
By Gary Gildersleeve
Partner & Fixed Income Portfolio Manager
Despite the sudden sell-off at the beginning of last month, the municipal market has changed little since mid-October. Municipal yields have declined, but only slightly. Yet the drumbeat of concern in the press about the health and viability of the market has grown only louder. Nonetheless, we still find selective, attractively priced issues to buy, primarily in the new issue market – many in the 7- to 12-year range. To pick up yield in lieu of cash, we remain focused on research-driven, short-duration securities, plus high-coupon issues priced to short calls. We are still pursuing geographic diversification, which can be achieved while increasing yields after factoring in state income taxes. We also continue to avoid the general obligation and appropriation debt of most states and major cities, preferring essential-purpose revenue and dedicated tax bonds.
What’s at the center of the debate about the health of municipal issuers? In two words: structural imbalances. State and local municipalities have seen precipitous declines in revenues from sales, income and capital gains taxes – just as long-term pension liabilities have been rising. For many states, operating deficits have not been as severe as anticipated, thanks to federal stimulus money that helped cover operating costs. But if Washington does not renew this program and revenues do not recover sufficiently, state and local governments will have persistent operating deficits. Exacerbating the fiscal pressure has been broad deterioration in funding levels for public sector pensions. Some state and local governments face a triple whammy of more retirees, more expensive retirement benefits (granted in lieu of pay raises), and significant investment losses.
Investors should not underestimate these potentially protracted imbalances, but neither should they paint all municipals with the same brush. Remember, municipalities can balance their books with a broad array of tax increases and service cuts. Some governments in fact address budgetary imbalances during the course of their fiscal years, rather than waiting for scheduled budget negotiations. Some establish rainy-day funds by putting away money during flush times. Audited disclosure of funding for pension programs has greatly improved, and we look for issuers that have aggressively funded this long-term liability or have renegotiated pension benefits for new employees.
Our preference remains for issuers that, thanks to the tax structure or the underlying economy in their regions, are not as prone to large fluctuations in revenues. Given financial constraints, we tend to favor essential-purpose revenue systems with monopolistic control over their customer bases and independent rate-setting ability. Many essential-service enterprises have effectively dealt with the pension issues or are not as labor-intensive as some state and municipal entities.
Any major moves in U S Treasury yields will certainly influence the overall direction of the market, and many dealers – anxious to protect this year’s record trading profits – are likely to be reluctant to stock additional inventory. However, we still consider the supply of municipal new issues between now and year-end an opportunity to find attractively priced deals.
Gary Gildersleeve joined Evercore Wealth Management as a founding partner in 2008 with over 33 years of experience in managing fixed income investment strategies for high-net-worth individuals.
Municipal Market Update: Opportunities Exist (Word Document)
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