Weekly Market Update
The last four years have been a remarkable period in municipal bond (muni) market history. The 2008 Financial Crisis and the Great Recession transformed the high-grade U.S. muni market and how people invest in it. What was once a relatively homogenous bond sector in terms of its credit quality and ratings became much more heterogeneous. Under these conditions, we believe experienced professional credit research and portfolio management are now crucial to investment success. This article outlines our muni investment processes.
From Insured to Uncertain
Prior to 2008, investors seeking the potential muni benefits of tax-free income and diversification could secure muni exposure fairly easily without much credit expertise. Within the rather “vanilla” high-grade market, most muni bonds (approximately 55% of new issuance, as recently as 2005) were insured by bond insurers, such as AMBAC, MBIA, and FSA.
Insured bonds generally carried AAA credit ratings from the three major credit rating agencies (CRAs—Moody’s, Standard & Poor’s, and Fitch), creating a perception in the investment community of few, if any, credit risks for these securities. That’s because the bond insurers guaranteed the timely repayment of principal and interest in the event of a default.
Dramatic Changes in 2008
These dynamics changed dramatically, beginning in 2008. As credit markets deteriorated, so did the credit ratings of the bond insurers. The insurers, unfortunately, had expanded their coverage to include bonds backed by subprime mortgage debt. The collapse of the subprime mortgage market and the resulting huge payout liabilities crippled the bond insurers’ ability to insure newly issued munis.
Today, only 5% of newly issued muni bonds offer insurance protection, and that insurance protection is no longer rated AAA. Without bond insurance, muni investors have been forced to evaluate the underlying credit quality of all munis that they’re considering, a task that’s much more difficult than buying bonds with insurance.
Meanwhile, the credit crisis also contributed to a rapid deterioration in the nation’s economic health. State and local governments began facing severe budget shortfalls as their tax revenues plunged. This, too, has led to ongoing credit quality concerns and uncertainties.
Tax revenues and fiscal conditions have improved from the nadir of the credit crisis, but they remain below pre-recession levels. We think they will continue to lag as long as the housing and employment markets remain depressed and the economy stays sluggish.
Credit Research and Analysis Rise in Prominence
Although events of the last four years have shaken up the high-grade muni market, they have also created opportunities for expert, experienced muni portfolio managers to add and deliver value to investors. Changing muni market dynamics have brought to the forefront the importance of thorough, experienced credit research and analysis and professional portfolio management. These qualities have always formed the cornerstones of American Century Investments’ muni team and the portfolios we manage.
Independent, third-party CRAs can help provide perspective on credit quality. However, we believe they should not be the final word in credit quality for serious investors in credit-sensitive markets. They can be/have been notably late to react to changing financial conditions. (Take the subprime meltdown, for example, when many subprime-backed securities were rated AAA up until the time they collapsed.)
Therefore, to navigate today’s volatile credit climate, we believe you need more than CRA bond ratings for guidance. We think you need detailed, in-depth, proprietary credit analysis, as part of an integrated professional portfolio management approach. We think the constant vigilance, evaluation, and valuation processes required are beyond the scope of most advisors and individual investors.
Muni mutual funds supported by professional credit analysts and experienced portfolio managers are our suggested solution for finding muni values and credit improvement upside in this challenging credit environment.
Seasoned Team, Rigorous Process, Unique Structure
American Century Investments’ experienced muni team has actively managed muni portfolios since the early 1980s, successfully weathering many market and economic cycles. Our team consists of five credit analysts, three portfolio managers, and two risk management professionals working closely together to select securities and build muni portfolios intended to achieve competitive, but still bond-like, total returns.
We recognize that tax-free income is an important objective in this sector. It’s a goal we actively seek, but it’s not an “end-all” to us. Total return is our primary focus, not yield. As we’ve seen repeatedly in the muni market in the past decade, over-pursuit of yield can lead to equity-like portfolio volatility for bond funds and excessive correlations with equity performance. We strive to create and manage portfolios that behave like bonds, not stocks.
To do this, we’ve created what we believe is a rigorous, repeatable, disciplined, risk-managed institutional-quality investment process. We’ve applied this process to what has historically been an individual investor-oriented sector of the market.
We also believe our muni portfolio management and security analysis structure is relatively unique, with its integration of the risk management team. We believe few muni teams have a dedicated risk-management team like ours, and if they do, they serve more in a compliance capacity than as part of the portfolio construction process.
Heart and Soul of Our Process
But, after all is said and done, we think the heart and soul of our muni process is our dedicated municipal credit research and analysis team. In addition to their industry experience and background, our five analysts have remarkably long tenure with our firm (averaging nearly 14 years per team member).
These analysts also bring sector-specific insight and expertise to the process. We encourage our muni credit analysts to specialize in credit sectors so they can gain a thorough understanding of their sectors’ opportunities and risks. The credit research team’s experience and expertise is interwoven throughout the security selection, portfolio building, and management processes.
Custom Benchmarks Help Drive Decision-Making
Before we apply fundamental research to individual securities, we screen them for eligibility for our security selection process. The screening starts with custom-designed benchmarks for each fund’s portfolio, created from a muni market benchmark index of more than 10,000 individual securities.
By using various criteria to sort and filter the index, we end up with a smaller subset of securities that we believe are most likely to be invested in by the mutual fund industry, eliminating small, local issuers. The result is a custom index for each fund that we believe is representative of the median fund in each portfolio’s peer group.
We believe using custom benchmarks, and actively managing against those benchmarks, allows us to effectively monitor each fund’s relative exposure to duration, yield curve, sector weights, and individual securities. We can actively manage each factor in a manner that reflects the team’s convictions in those particular areas.
Because the custom benchmarks represent neutral positioning, we can implement and manage various exposures to achieve our desired risk positioning for each fund. At the same time, we can limit unintended overexposure and manage risk in each area.
Establishing Convictions and Positioning
We use a team approach to determine our investment convictions and establish our portfolio positioning in terms of duration, yield curve, sector overweights and underweights, and security selection—the factors that typically generate the largest excess return potential in our muni portfolios.
It starts with our Fixed Income Macro Strategy Team (six senior bond sector and discipline team leaders, including fixed income CIO David MacEwen), who provide a macro (economic and market) overview that helps determine duration, yield curve, and sector allocation targets.
Then, working together, the entire muni team determines which muni sectors to overweight and underweight. We base these decisions on various factors, including:
- Our analysts’ outlook for each sector;
- The technical aspects (issuance, spreads, etc.) expected to influence the sector;
- Macro influences; and
- Risk management considerations.
We apply the decisions we make to the portfolios built from the custom benchmarks, with one additional important step, outlined below.
Each Security Faces Detailed Review
The credit research team conducts fundamental analysis of each individual security that has made it through the earlier screens. This detailed process typically includes:
- A detailed evaluation of the issuer’s/borrower’s credit fundamentals;
- An analysis of the transaction documents;
- An assessment of any third-party ratings; and
- Site visits, primarily for lower-quality issuers or those with unique credit circumstances.
The analysts store the results of their comprehensive evaluations on an internal database and assign a proprietary rating to each security.
When the credit analysts deem securities investment-worthy, they discuss their ideas with the portfolio management team. The entire group conducts a relative value overview of each security, examining its fundamental and technical attributes in relation to its pricing and total return potential.
If the security’s characteristics and structure represent a good fit for the fund, we will purchase the security. Then, the credit analysts will conduct ongoing monitoring of the security, to make sure it continues to perform as expected.
We take pride in assuring investors that every security in an American Century Investments’ muni fund has gone through a rigorous credit review and approval process and will continue to undergo intense scrutiny for as long as the fund owns it. This detailed municipal credit research and security selection and evaluation process has helped our muni portfolios avoid or reduce exposure to many credit-related potential pitfalls, including volatility in the airline and tobacco sectors and specific headline-making municipal default situations.
Though past performance is no guarantee of future results, we believe the total returns of our funds accurately reflect the care and attention we take in terms of our muni research, analysis, and risk management processes.
Funds for Today’s Muni Market
Through seasoned, professional credit analysis and portfolio management, combined with a risk-management overlay, we believe American Century Investments’ muni funds are positioned to deliver an institutional-caliber investment process from which tax-exempt income-seeking investors can potentially benefit.
In today’s challenging economic and market environment, we believe sound, experienced credit analysis is more important than ever in securing strong muni performance potential and diversification for committed fixed income investors.
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Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
Investment income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax (AMT). Capital gains are not exempt from state and federal income tax.
This information is for educational purposes only and is not intended as investment or tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
Diversification does not assure a profit, nor does it protect against loss of principal.
Letter ratings indicate the credit worthiness of the underlying bonds in the portfolio, and generally range from AAA (highest) to D (lowest).
The opinions expressed are those of Steven Permut, David Moore, and the fixed income portfolio management team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.