Evolving municipal bond market makes compelling case for active management pot
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The classic strategic reasons to own municipal bonds still hold true: They generally
have low correlations to other asset classes and oer a meaningful tax advantage
to investors — features that are unlikely to change in the near term. However, the
municipal bond market has experienced a significant shift over the past several years
through the virtual demise of municipal bond insurance and the stress of highly
constrained federal and state budgets. This paper will examine how these changes in
the municipal bond market have had an impact on the evaluation of municipal securi-
ties, whether it makes sense to invest in municipal bonds today, and how investors
might need to change the way they implement their investment strategies as a result.
Figure 1. Municipal bonds are not highly correlated with other asset classes
Municipal bond correlations versus other assets (1/31/92–12/31/11)
0.03
0.09
0.30
0.59
0.69
AA 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: Barclays Capital Bond indices, Standard & Poor’s.
Stacking up yesterday versus today
In comparing the municipal bond market from 10 years ago with today’s market,
many characteristics remain consistent. A decade ago, the top five state issuers were
California, Florida, Illinois, New York, and Texas and represented roughly 50% of the
market; this is still true today. In fact, nine of the top ten issuers from 2001 were still on
that list in 2011, and continued to constitute approximately 65% of the market.
Among the changes has been a general trend away from local general obligation issu-
ance toward issues backed by special taxes or assessments. In many instances, the
issuance of general obligation debt requires voter approval. One way to avoid going
through that process is to issue special tax/assessment debt, which may require no
• Municipal bonds remain
strategically important
investments with significant
tax advantages and generally
low correlations to other
asset classes over time.
• The near elimination of bond
insurance has dramatically
changed the municipal
ratings landscape.
• Municipal bond fundamentals
are helped today by low
defaults and attractive
spreads over Treasuries.
• Actively managed funds
driven by fundamental
research can help add
broad diversification and
mitigate risk.
Key takeaways
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, CFA
Portfolio Manager
PUTNAM INVESTMENTS | putnam.com 2
FEBRUARY 2012 | Evolving municipal bond market makes compelling case for active management
vote or a vote by a more limited group of taxpayers. This
shift could also be considered an indication of investor
preference for “clean” flows that other governmental
entities are not allowed to access, as well as generally
reliable covenants supported by rule of law.
Figure 3. An increase in issues backed by
special taxes/assessments reflects a tougher
budgetary environment
Distribution of municipal sectors
Sector distribution (%) 12/31/01 12/31/11 Change
Stategeneralobligation
Transportation -
Localgeneralobligation -
Specialtax
Water&sewer
Hospital -
Leasing
Education
Power -
Other() -
Source: Barclays Capital Municipal Bond Index.
However, the key shift in the market has been the
considerable change in credit quality distribution.
As of December 31, 2001, the AAA segment of the
municipal bond market represented approximately
60% of the market; that figure has declined to only 13%
today
(Figure 4)!
1
This major change can be attributed
to two factors: most important, the near elimination
of bond insurance for the municipal market, but also
the downward migration of municipal ratings in the
wake of significant fiscal stress at both the federal and
state levels. At its peak over the past 10 years, bond
insurance was used in 57% of municipal securities
issued in 2005, with the bulk of the underlying securities
carrying insurance rated single A. (As seen in the
2001 credit quality chart of Figure 4, if bond insurance
had been stripped out, the municipal bond universe
would have had a significantly higher concentration of
A-rated securities, rather than a AAA-rated segment
representing more than 50% of the market.)
In 2011, usage of bond insurance declined to a mere 5%
(Figure 5). This precipitous drop in bond insurance began
in 2008 as the insurers experienced mounting losses
associated with guarantees on subprime mortgage-
backed debt. As a result, insurers were downgraded and
lost their top ratings or entered bankruptcy. Without the
ability to achieve a top rating and therefore lower their
debt costs, most municipal bond issuers lost the incen-
tive to pay for the additional credit enhancement.
The decline of insurance is only one of the factors
contributing to the downward trend in credit quality.
Moody’s Investors Service reported the downgrade-
to-upgrade ratio for the third quarter of 2011 at
approximately 5.3 to 1. This is the highest ratio since the
1 Barclays Capital, Barclays Capital Municipal Bond Index.
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
12/31/11
12/31/01
Washington Pennsylvania Puerto Rico New Jersey Massachusetts Illinois Florida Texas New York California
Source: Barclays Capital Municipal Bond Index.
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FEBRUARY 2012 | Evolving municipal bond market makes compelling case for active management
beginning of the financial crisis in 2008; however, the
absolute number of downgrades in the third quarter
(163) was less than the peak experienced in the fourth
quarter of 2010 (197). While downgrades may be high
by historical standards, keep in mind that they repre-
sent a small portion of the Moody’s-rated public finance
universe in the third quarter: less than 1% (Figure 6).
2
2 Moody’s Investors Service, U.S. Public Finance: Third Quarter Sets
New Peak for Ratio of Downgrades to Upgrades, November 1, 2011.
Value to be found
Given these structural changes, investors may be
wondering whether municipal bonds continue to warrant
an allocation. We believe municipal bond investments are
potentially quite attractive: Defaults have remained low,
contrary to overblown predictions in the media; spreads
are attractive on a historical basis; and muni/Treasury
ratios are still above historical averages.
Defaults in the municipal bond market are generally
misunderstood. While defaults do happen, they occur
with far less frequency than in the corporate bond
Figure 4. The decline of bond insurance has sharply reduced the availability of AAA bonds
Credit quality composition
12/31/01 12/31/11
BBB
A
AA
AAA
Source: Barclays Capital Municipal Bond Index.
Figure 5. Bond insurance as a percentage of total municipal new issuance
0
10
20
30
40
50
60%
20112010200920082007200620052004200320022001
Source: The Bond Buyer, 2011.
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FEBRUARY 2012 | Evolving municipal bond market makes compelling case for active management
market, and more often than not, they are confined to
particular sectors of the market, typically in land devel-
opment deals or unrated securities. We believe bond
insurance had very little impact on historical default
statistics; the insurers generally provided credit enhance-
ment for single-A deals and not for those at the low end
of the rating spectrum, which are more prone to default.
When defaults occur, they tend to capture headlines.
Recently, American Airlines’s $3.2 billion in municipal debt
as well as approximately $15 billion in tobacco settlement-
backed debt were added to default statistics although
no payments have been missed; these “defaults” were
due to the particulars of the calculation methodology
that has been used for many years by the Distressed Debt
Securities Newsletter. The methodology includes tech-
nical defaults as well as bankruptcies and other forms of
non-monetary default, e.g., accessing reserve funds, as is
being done in the case of the tobacco bonds.
Jeerson County, Alabama — another headline-grabbing
default in 2011 — had been in negotiations for several
years trying to work through its fiscal issues; however, the
county recently opted to file for bankruptcy and became
the largest municipal bankruptcy in U.S. history at $4
billion. The county’s general obligation debt of about $1
billion was also recently added to the default statistics.
While municipal defaults have ticked up recently, it is
important to note that the predicted massive number
of defaults has not materialized. Nearly one year ago,
one well-known analyst predicted 50 to 100 sizeable
defaults, totaling hundreds of billions of dollars. Those
fears are proving to be unfounded. In fact, 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 7).
3
This is not to say
that there will not be future defaults in the municipal
market; there will be. But the fundamental budget stress
at the heart of the current struggles will slowly ease as
the fiscal measures being put into action by the states
and municipalities begin to take eect and as the U.S.
economy continues to improve.
3 Moody’s Investors Service, U.S. Municipal Bond Defaults and
Recoveries, 1970-2009, February 2010.
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, defaults are low as a percentage of the total market
Municipal defaults since 1990
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7%
2011201020092008200720062005200420032002200120001999199819971996199519941993199219911990
Sources: Distressed Debt Securities Newsletter, Putnam, as of 11/21/11. Municipal market is estimated at $3.7 trillion.
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FEBRUARY 2012 | Evolving municipal bond market makes compelling case for active management
Figure 7. At every credit rating, corporate defaults
outpace those in the muni market
Moody’s 5-year average cumulative default rates
Rating Municipal Corporate
Allrated
Aa
A
Baa
Ba
B
Investmentgrade
Speculativegrade
Source: Moody’s Investors Service, U.S. Municipal Bond Defaults and
Recoveries, 1970-2009, February 2010.
It is worth noting that recoveries in the municipal market
also run higher than is typical in the corporate credit
market, though the range is quite wide. For the Moody’s-
rated defaults occurring from 1970 to 2009, the average
recovery rate was approximately 67%, while the range
was anywhere from below 5% to 100%.
4
For example,
the 1994 Orange County, California bankruptcy was the
largest municipal bankruptcy in history at that time, but
what few investors recall is that all principal and interest
payments were made. Compare this with the average
corporate recovery rate of 41% from 1982 to 2009.
5
That
is roughly a 25% dierence; recovering a quarter more in
value is quite meaningful.
4 Moody’s Investors Service, U.S. Municipal Bond Defaults and
Recoveries, 1970-2009, February 2010.
5 Moody’s Investors Service, Corporate Default and Recovery Rates,
1920-2009, February 2010.
With that backdrop in mind, spreads on credit tiers
below AAA look attractive compared with their historical
averages. The presence of bond insurance primarily
influenced the AAA credit sector, so focusing on AA
and below is a better measure of historical spread levels.
Current spreads range from 20 basis points to over 100
basis points for securities rated AA to BBB versus their
historical averages over the past 13 years (Figure 8).
6
If the volatile time period of October 2008 through
December 2011 is excluded, the comparison of current
spreads to a “normalized” time period (January 30, 1998,
to September 30, 2008) illustrates that today’s spreads
are 50 (AA) to 150 (BBB) basis points wider than would
typically be expected. 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.
Another measure of the attractiveness of municipal
securities is the comparison with U.S. Treasury securi-
ties, generally referred to as the muni/Treasury ratio.
Typically, the AAA-rated municipal yield is compared
with the yield of a similar duration U.S. Treasury security.
Current muni/Treasury ratios for 5-, 10-, and 30-year
maturities are at levels approximately one standard
deviation away from their long-term averages. In part,
this is the result of the absolute low level of rates as well
as the generally wider spread levels of municipal bonds.
But the results are significant: Simply stated, investors
are able to buy 30-year AAA municipal securities that
out-yield a 30-year U.S. Treasury bond on a pretax basis.
After taxes, investors further benefit from the tax-free
income oered by municipal bonds.
6 Putnam Investments.
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.
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FEBRUARY 2012 | Evolving municipal bond market makes compelling case for active management
Figure 8. Spreads remain elevated at higher credit ratings
Historical municipal spreads (bps), 1/30/99–1/17/12
BBB
A
AA
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Putnam Investments, as of 1/17/12.
Implementing an investment strategy
To summarize the municipal bond landscape:
•Credit fundamentals are weathering the storm much
better than anticipated
•Defaults remain low
•Credit spreads and muni/Treasury ratios are attractive
relative to historical levels
•Research and active management are even more impor-
tant after the virtual disappearance of bond insurance
But what is the best way to implement a municipal bond
strategy given the changes in the marketplace and the
current environment? A portfolio of laddered individual
bonds or shares of a mutual fund? Investment grade or
high yield? National or state-specific? There are several
ways to implement a municipal strategy, and the primary
consideration must always hinge on what is suitable for
the individual investor. Assuming that risk tolerance, time
horizon, etc., is determined, one or more of the methods of
implementing a municipal strategy may be appropriate.
In many cases, a municipal bond investment strategy
will consist of a concentrated number of individual
bonds laddered by maturity date. Without being able to
rely on bond insurance to provide a guarantee of prin-
cipal and interest payments, the research and review
of an issuer and the provisions of the security are more
important than ever before. There are approximately
50,000 issuers in the municipal market, and they are far
from uniform, with each having its own specific nuances
relating to the bond covenants or some aspect of that
particular bond structure. Unfortunately, many advisors
and investors may not be aware of the best way to find
the necessary information on the bond or may not have
the time or expertise to do the thorough review needed
to avoid potential pitfalls. Relying on rating-agency
designations provides some relative sense of quality,
but that first step is not a sound credit strategy in and of
itself and, we believe, is not an optimal way to avoid the
potentially large losses an investor could face in a port-
folio with only a few individual bond holdings.
Investing in funds is a good way to leverage vastly
greater diversification benefits as well as profes-
sional fund management coupled with the expertise
of a seasoned research team. 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. This capacity is of
heightened importance today with the far less promi-
nent role of bond insurance and issuers continuing to
work their way through the financial crisis.
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FEBRUARY 2012 | Evolving municipal bond market makes compelling case for active management
An actively managed fund also provides a vehicle that
may trade opportunistically, typically at lower costs due
to more ecient block trading. Moreover, the manager
may employ strategies such as sector or quality rota-
tion, and more flexible yield curve positioning, both of
which are dicult if not impossible for investors building
their own laddered portfolios. Additionally, investors
are able to redeem a portion or all of their investment at
any time, while individual bonds can be dicult to liqui-
date.
7
Funds also typically pay regular, monthly income,
although that income typically fluctuates and is not fixed.
That being said, a fund is a more transparent vehicle,
with market moves reflected in the calculation of net
asset value on a daily basis. Lastly, it is worth noting that
fees may potentially be higher in a mutual fund than in a
laddered portfolio due to greater administration costs.
Given the many benefits of using a mutual fund to access
the municipal bond market, investors using a portfolio
of laddered bonds may consider adding a fund as a
complement to their existing holdings. For example,
if the investor owns primarily AA-rated bonds, it may
make sense to invest the proceeds of the next maturing
individual bond into a tax-free high-yield fund, which
could potentially add quality diversification as well as
increased yield. Alternatively, the investor may own
several state-specific bonds. Adding an investment in a
7 Share price, principal value, and return will vary, and there may be
a gain or a loss when shares are sold. In addition, review the fund
prospectus as certain funds may enforce short-term trading policies.
national municipal bond fund can dramatically broaden
the investor’s diversification. In sum, introducing actively
managed municipal bond portfolios could add greater
diversification and more thorough risk mitigation, and
provide a broader opportunity set for increasing value.
While the municipal market has evolved in recent years,
municipal bonds remain strategically important invest-
ments with significant tax advantages and generally low
correlations to other asset classes over time. Currently,
we believe this may be an attractive entry point for
municipal bond investors, and one way to do that is to
use actively managed funds in place of or as a comple-
ment to individual bonds. Relying on professional
managers and deep research teams to take advantage
of timely opportunities provides not only the potential
for additional return for investors but broader diversifi-
cation and risk mitigation in a market environment that
is much more challenging to navigate today than it was
only ten years ago.
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
years
years
years
Sources: MMD, Bloomberg, Putnam Investments, as of 1/20/12.
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.
FEBRUARY 2012 | Evolving municipal bond market makes compelling case for active management
EO144 273370 2/12
Thalia Meehan is a Portfolio Manager within Putnam’s
Tax Exempt Fixed Income Group. She earned a B.A.
from Williams College, is a CFA charterholder, and has
worked in the investment industry since 1983. She is a
member of the Boston Security Analysts Society and
the Society of Municipal Analysts.
Paul Drury is a Portfolio Manager within Putnam’s Tax
Exempt Fixed Income Group. He earned a B.A. from
Suolk University, is a CFA charterholder, and has
worked in the investment industry since 1989.
Susan McCormack is a Portfolio Manager within
Putnam’s Tax Exempt Fixed Income Group. She earned
a B.A. from Dartmouth College and an M.B.A. from
Stanford 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: Capital gains, if any, are taxable for federal and, in most cases, state purposes.
For some investors, investment income may be subject to the federal alternative minimum tax. Income from federally
exempt funds may be subject to state and local taxes. Funds that invest in bonds are subject to certain risks including
interest-rate risk, credit risk, and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more
exposed to interest-rate risk than short-term bonds. Unlike bonds, bond funds have ongoing fees and expenses.
Diversification does not assure a profit or protect against loss. It is possible to lose money in a diversified portfolio.
Data is historical. Past performance is not a guarantee of future results. As with any investment there is a potential
for profit as well as the possibility of loss.
Request a prospectus, or a summary prospectus if available, from your financial representative or by calling
Putnam at 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other
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