Hugh McGuirk: A lot of people get worried about the Muni market because of the highly publicized problems that exist. But I certainly want to remind your readers that the Muni market is still a very high quality market, and issuer fundamentals remain generally sound -- despite there being areas of concern. Nonetheless, there‘s a lot of opportunity in the Muni market and if you do the right credit research and pick the right bonds, then I think there are some excellent returns for investors available in the market.
At T. Rowe Price, we manage about $22 billion in municipal assets including a number of mutual funds and separate accounts whose mandates span the full maturity and credit quality spectrum, including a number of state-specific funds -- some of which I manage -- as well as six national funds and a number of long-term separate account relationships.
We integrate a couple of investment themes into our portfolios, with one of the more prominent ones being our preference for revenue bonds over general obligation (GO) debt. Traditionally, our market considers general obligation bonds to be the highest quality bonds in our market. However, we are finding better opportunities to invest in revenue bonds rather than general obligations, based on a couple of factors.
We have long-term concerns about the willingness and ability of many state and local governments to address their long-term liabilities related to pensions and retiree health care benefits. And, given the recent results from Detroit’s exit from bankruptcy where retirees received more favorable treatment than bondholders, this reinforces our bias for revenue bonds over GO debt as a fairly good path to take. The City of Chicago’s recent downgrade to below investment grade is an additional data point that supports our overarching view.
Revenue bonds, which make up about two-thirds of our market at issuance, with the other third being general obligations, are typically project revenue bonds whose cash flows are secured by specific revenue-generating assets or dedicated taxes. For instance, there are water, sewer system or utility revenue bonds, which, generically, we refer to as essential service revenue bonds. We prefer revenue bonds for the specific claim on revenues that we have as bondholders, rather than the generic full faith and credit that goes with general obligations. Single-project revenue bonds are also more insulated from the pension funding risks.
Within revenue-backed debt, we like a couple of sectors. One is the transportation area that includes airports or toll roads. We're fond of saying that in state and local government, monopolies work for us. So for instance, think of an airport. There aren't many competitive alternatives for an airport. Typically demand is dependent on the city or the state where it's located. As long as we have good claims on those airport revenues, the airport is in a thriving economic area, and they pass through our usual credit research process, we think there are a lot of good opportunities in that sector.
Wally Forbes: Now do you buy them individually or do you recommend combinations of holdings or what?
McGuirk: We buy bonds individually. We're investing on behalf of the mutual funds that T. Rowe Price manages for our individual investors but we're investing in individual bonds. Despite perhaps some challenges related to the Affordable Care Act and general fiscal challenges that hospitals face, we also like the hospital sector because we think it's a good long-term source of extra income in the Muni market. But like many of the other sectors in our market, you have to make sure you own the right ones.
Forbes: Can you suggest any specific ones at this time?
McGuirk: It's difficult to say, Wally. It's a very highly fragmented market with 50,000 issuers in a very large $3.7 trillion market. I wouldn't want to point investors towards one particular issue here or there, because they just might not be able to find them.
I prefer to say generically if you’re an individual investor buying bonds directly in the hospital sector for instance, you need to make sure you understand what your security is, what your priority of claim on revenue is, and what the quality of the income statement and balance sheet of that particular hospital is. We operate based out of Maryland and there are a number of very good hospital systems in the state. I think our approach in Maryland is emblematic of how we approach our investments around the country, in that we want to make sure that, not only do we understand the financial statements of our issuers, but we want to make sure we understand management and their strategy, and their long-term direction because these factors make a difference in the quality of the operation.
Forbes: Is this kind of data going to be available to individual investors, or should they go through professionals, rather than try to pick individual securities themselves?
McGuirk: We are finding more and more individuals are relying on professional managers to help them invest in the municipal market. Think about how the Muni market was ten, 15 years ago, Wally. It was dominated by the insurers with 85% AAA and AA ratings. There wasn't a lot of spread difference between a AAA or an A or BBB rating. With the demise of insurers, in '08 in particular, credit spreads really widened. And today, only about 60% of our market is AA and AAA.
And while the Muni market is overwhelmingly a high quality market, there are a lot more spots where individual investors, if they're buying bonds directly, can get tripped up. That's why you need to make sure that you know what it is that you're buying. What is your order ranking to receive the revenues of the issuing authority? What is your security and how high is the quality of the balance sheet of the particular entity that you're investing in?
Forbes: Well, it sounds like it'd be difficult since there are so many individual bonds out there.
McGuirk: Overall in the market, about 50% of outstanding Munis are held directly by individuals.
Forbes: That's very interesting.
McGuirk: Another close to 20% is held in mutual funds. But individuals still dominate the Muni bond market.
Forbes: Any other sectors that you're interested in beside the transportation and hospital sectors?
McGuirk: People are worried about what the Federal Reserve is going to do. So it's kind of a natural inclination for people just to say, "Well, you know, I'm scared about interest rates so I'm going to stay short on the curve and not take any risks."
But at T. Rowe, we see that there's a lot of value on the longer end of the curve. The spread from two years to 30 years is still pretty steep -- historically. So you can pick up a lot of income as you go out the curve, but there's more interest rate risk. But if you think about an instance of where the Federal Reserve is pushing the front end rate higher -- which they will eventually, whether it's this year or next -- we think the front end is much more volatile and much more vulnerable, rather, than the long end. In a year, we think the curve will be flatter and probably at higher rates. But we think the magnitude of the move on the front end is going to be a lot bigger than the magnitude of the move on the long end. And the extra income that you get on the long end is a pretty good cushion for any eroding of principal that you might experience if rates do go higher.
Forbes: That's very interesting and very helpful. Let me ask you this. You said that 50% of the muni market is held by individuals. Do they tend to be more local to the area, in terms of buyers of Munis?
McGuirk: I'm not sure where I would go to find that data, but I think that most individuals tend to invest locally in their own state because of familiarity and for tax reasons. So it might be a hospital system near them that they see on a daily basis, or a city or a county that they're very familiar with. I believe it's the general tendency of individuals to invest in areas they know. And of course, there's a tremendous tax advantage if you can avoid both federal and state tax.
Forbes: Hugh, this has been very interesting and very different from the equities markets that we usually cover.
McGuirk: Wally, thank you very much for having me join in.
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