Evolving municipal bond market makes compelling case for active management pot

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

The classic strategic reasons to own municipal bonds still hold true: They generally have low correlations to other asset classes and offer 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 instissu-ances, 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.

Evolving municipal bond market makes compelling case for active management

Thalia Meehan, CFA

Portfolio Manager

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

State general obligation 15 17 +2

Transportation 16 15 -1

Local general obligation 20 13 -7

Special tax 3 11 +8

Water & sewer 8 9 +1

Hospital 9 9

-Leasing 5 8 +3

Education 5 7 +2

Power 10 7 -3

Other (< 3%) 9 5 -4

100 100

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

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.

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

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%

2011 2010

2009 2008

2007 2006

2005 2004

2003 2002

2001

Source: The Bond Buyer, 2011.

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

Jefferson 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 effect 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%

2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992

1991

1990

Sources: Distressed Debt Securities Newsletter, Putnam, as of 11/21/11 Municipal market is estimated at $3.7 trillion.

Figure 7 At every credit rating, corporate defaults

outpace those in the muni market

Moody’s 5-year average cumulative default rates

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% difference; 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 offered 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.

Figure 8 Spreads remain elevated at higher credit ratings

Historical municipal spreads (bps), 1/30/99–1/17/12

0

100

200

300

400

500

BBB

AAA

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

An actively managed fund also provides a vehicle that

may trade opportunistically, typically at lower costs due

to more efficient 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 difficult 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 difficult 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

Jan 20, 2012 Since 1990 Since 1998 Since 2000 Since 1990 Since 1998 Since 2000

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.

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

Suffolk 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