With growing concerns about an increase in defaults among state and city governments, money managers are ratcheting up their efforts to reduce the levels of risk in their municipal bond portfolios.
In recent months, officials from a number of municipalities, including Harrisburg, Pa., have talked about bankruptcy, prompting many mainstream media outlets to highlight the potential for massive defaults in the muni market. For instance, in May, Time magazine published an article headlined “Municipal Bonds: The Next Financial Landmine.”
But experts note that the potential for muni bond defaults remains limited to smaller issuers in certain sectors, such as real estate. So far this year, there have been $23 billion in muni defaults in a $2.8 trillion market, according to Municipal Market Advisors.
“The most popular question I get these days is, "Will the entire muni market go out of business?'” said John B. Cummings, executive vice president and head of the muni bond desk at Pacific Investment Management Co. LLC.
He said that people also ask “whether California is the next Greece.”
Although portfolio managers don't think that there will be massive defaults in the muni bond market, they realize that if investors even perceive such a risk, it could pose liquidity risk for their portfolios. As a result, many managers, such as Standish Mellon Asset Management Co. LLC, Eagle Asset Management, Inc. and Pimco, are taking action to address their liquidity risk.
“There is a growing perception that the U.S. municipalities are comparable to the sovereign debt in countries such as Portugal and Spain,” said Christine Todd, managing director of tax-sensitive strategies at Standish, a subsidiary of
BNY Mellon Asset Management that specializes in fixed income. “The problem is, perception becomes reality.”
Financial advisers are more concerned than ever about the risk in the muni market, Ms. Todd said.
“As a muni manager, in the past, we could barely get anyone to pick up our calls,” she said. “Now we get a flurry of calls every time there is an article in the paper on this.”
One of the biggest risks that muni bonds face is the public perception that there is about to be a wave of defaults among municipalities, Ms. Todd said.
The potential risk is that as rumors about the pending fall of municipalities gains traction, it will cause liquidity problems for the muni market because that liquidity is so reliant on retail investors, she said.
Regardless, Standish has spent the past several months unwinding the credit risk of its muni bond funds, Ms. Todd said. The firm has sold out of the lowest-quality bonds.
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Standish also has begun significantly underweighting general-obligation portfolios, Ms. Todd said.
“It's a legitimate concern that credit quality is deteriorating,” she said. “But we don't think we will see widespread defaults in the general-obligation market.”
Many money managers have cashed out of bonds in the states with the most headline risk, such as California and Illinois.
“We are getting out of many of the names that are subject to the biggest headline news, because [they] are the biggest problems,” said Marilyn Cohen, president and chief executive of Envision Capital Management Inc., which oversees $275 million in bonds for individuals.
Investor skittishness is causing some managers such as Pimco to hold more in cash in their muni bond portfolios.
“I have been running slightly more in cash over the last six months,” Mr. Cummings said.
Eagle Asset Management is holding about 4% of its muni bond portfolios in cash, up from 1% several months ago, said Burton Mulford, a portfolio manager and trader on the firm's fixed-income team.
At the same time, many managers, such as Eaton Vance Corp. and
Nuveen Investments Inc., are stepping up their research efforts to sniff out the potential for credit risk at different issuers.
“With most of the insurers being downgraded, there needs to be more research on all the bonds in the universe,” said Cindy Clemson, co-director of muni investments and a portfolio manager on Eaton Vance's muni bond team. Ten percent of new muni bonds issued are insured, down from 50% in 2008, according to the Municipal Securities Rulemaking Board.
Eaton Vance recently hired a re-searcher and plans to hire another analyst to bring its total team to nine people to address the increased need for vetting new muni bonds.
Nuveen has hired three research analysts over the past six months to bring its team up to 20 people, said John Miller, chief investment officer of
Nuveen Asset Management.
Additionally,
Nuveen is doing more credit reviews of high-quality bonds in its portfolios, Mr. Miller said.
Advisers are spending more time with clients talking about muni bond investments and in some cases are telling them for the first time to invest in out-of-state bonds instead of their hometown bonds — even if they don't get the tax break.
“Five years ago, I probably would have discouraged investors going out-of-state,” Ms. Cohen said. “That isn't necessarily the case now.”
E-mail Jessica Toonkel at [email protected].
