The wave of selling in Puerto Rico bonds that started in September pushed yield spreads to record highs. During that month, American Century Investment Management boosted holdings of commonwealth debt in its intermediate-term tax-free fund to 1 percentage point more than its benchmark index, said Steven Permut, who oversees about $6 billion of local debt as head of munis in Mountain View, California.
Permut also discussed why California is poised for another rating increase and the future of bond insurance for today’s Bloomberg Brief: Municipal Market Newsletter.
Q: How have you adjusted your Puerto Rico holdings given the increase in yields since September?
A: Our tax-free bond fund currently owns about 4 percent in Puerto Rico, which is about a 1 percent overweight versus the index. We view that as a moderate bet. Most of that overweight was purchased in September when spreads were quite wide.
In moderate amounts, Puerto Rico and Detroit can be used by professional managers to add alpha. But double-digit percentages aren’t appropriate, and an individual investor purchasing high-risk, high-profile names isn’t appropriate.
We put the overweight on as the trading value of Puerto Rico securities became attractive. We were basically flat to the benchmark for most of 2013, and then we added to our holdings in mid-September.
Q: Does your increase in Puerto Rico debt mean you believe the island’s economy is going to improve?
A: The economy is only one factor we’re viewing in Puerto Rico. The credit remains problematic from the standpoint of its political situation as well as its debt levels. But we believed fundamentals were being overshadowed by technical factors in the last three months. The fundamentals were much stronger than its trading value was indicating.
Q: Turning to California, are the yield spreads on general-obligation bonds there too narrow given the state’s strains just a few years ago?
A: On the long-end, California is at fair value. Down the curve, it has become on the richer side.
The bonds are still in the high single-A category from a credit standpoint. But with some of the changes and the remarks from the rating agencies, we wouldn’t be surprised within the next 12 to 24 months to see California receive a AA rating.
With the state improving its credit quality and tax rates on the wealthiest residents in the state going up substantially, even at these levels we view California as providing a role in an individual’s portfolio.
Q: Is there a need for bond insurance in the muni market now that investors have adjusted to life without much of it?
A: We don’t see a need for bond insurance for institutional investors, and we don’t believe the market will ever return to the pre-crisis levels where 50 or 55 percent of issuance was coming insured.
There’s a small niche for bond insurers for individual investors who are looking for a secondary guarantee of their principal payments. We will see a slow growth in bond insurance for those individual buy-and-hold investors, but I don’t believe we’ll see bond insurance get to double-digit penetration again.
Q: Do you have any concerns about how bonds are priced in the municipal market?
A: Pricing in the last few years has become much more transparent than it once was, with real-time pricing available to both institutional and individual buyers.
But in periods of stress and periods in which there are high-profile credits that come under pressure like Puerto Rico, pricing has become more of an issue and bears further watching.
Q: Are muni-bond buyers going to have to recalibrate their expectations headed into 2014 after a year of negative returns?
A: It is negative total returns, but we’re still talking about a very stable asset class. We’re not looking at double-digit returns like we’ve seen in past years, but for what people buy municipal securities for -- tax-free income, preservation of principal and high-quality, low-volatility investments -- they’ve basically provided it.
Being down 2 percent during a fairly bad time period in the fixed-income market to me signals the asset class is doing what it should do.
Q: What will stem the current streak of outflows from muni mutual funds?
A: There are going to be some surprises at year-end or April 15, 2014, when people file their taxes. There’s also been a fairly substantial phase-out of deductions for high-income earners.
That will make municipals, which continue to be dual exempt, more attractive and will bring more investors to the asset class than is currently being priced into the market.