Lyle Fitterer, the top manager of U.S. municipal-bond funds in the past decade, sides with Bill Gross and against Meredith Whitney in his view that fiscally strained states and cities will avoid widespread defaults.
“The baby has been thrown out with the bathwater,” said Fitterer, who runs the $2.3 billion Wells Fargo Advantage Municipal Bond Fund from Menomonee Falls, Wisconsin. “For every bad story there are hundreds of good ones.”
Investors have pulled money from mutual funds that buy municipal bonds for nine straight weeks, spooked by rising interest rates and warnings that defaults will escalate. Fitterer used the selloff to buy what he sees as bargains, including debt from Illinois and California, which have the lowest state credit rating from Moody’s Investors Service.
Whitney, the bank analyst who correctly predicted Citigroup Inc.’s dividend cut in 2008, in December forecast 50 to 100 “significant” municipal-bond defaults this year totaling “hundreds of billions” of dollars. Gross, manager of the $241 billion Pimco Total Return Fund, disputes her call.
“I don’t subscribe to the theory that there will be lots of them,” Gross said in a Jan. 12 interview on Bloomberg Television’s “InBusiness.”
The Total Return Fund, the biggest mutual fund in the world, holds about 3 percent of its assets, or more than $7 billion, in municipal debt, according to the website of Pacific Investment Management Co., the Newport Beach, California-based firm where Gross is co-chief investment officer.
“I am not saying there won’t be defaults,” Fitterer, 43, said in a telephone interview. “But I have a hard time getting to $10 billion, let alone $50 or $100 billion.”
Municipal bonds with a combined value of $2.7 billion defaulted in 2010, according to Distressed Debt Securities Newsletter.
Fitterer’s fund returned an annual average of 5.4 percent in the 10 years ended Dec. 31, the most among the almost 1,500 tax-exempt municipal-bond funds tracked by Chicago-based Morningstar Inc. The average gain for the group was 3.7 percent.
Thomas Metzold, co-director of municipal investments at Boston-based Eaton Vance Corp., called Whitney’s comments “outlandish and outrageous.” Metzold, who oversees $17 billion in municipal securities, said in a telephone interview that he has been putting more of his own money into muni bonds in the past few months.
“We are encouraged by what we are seeing from cities and states,” Robert Amodeo, head of municipal investments at Western Asset Management, the bond unit of Baltimore-based Legg Mason Inc., said in a telephone interview. Amodeo, who helps manage $23 billion in long-term municipal bonds, said local governments are starting to bring spending in line with revenue.
Fitterer, a graduate of the University of North Dakota in Grand Forks, has worked on the fund since 2000. He and his team look for mispriced bonds by studying the economy and researching the creditworthiness of individual securities. They manage $17 billion in municipal-bond mutual funds.
Wells Fargo Advantage Municipal Bond holds more low-rated bonds than the average for peers, said Greg Brown, a mutual-fund analyst with Morningstar. “It’s a fairly adventurous fund,” Brown said in a telephone interview.
Morningstar gives the fund five stars, its highest rating. The fund’s 10-year Sharpe ratio was 0.61, compared with 0.55 for its benchmark, the Barclays Capital Municipal Bond Index, according to Morningstar. The Sharpe ratio measures performance adjusted for risk.
More BBB Bonds
In the third quarter, Fitterer’s holdings of AAA and AA bonds, the top ratings assigned by Standard & Poor’s, was about half that of the Barclays index, according to the fund’s quarterly report. The fund held more BBB bonds than the benchmark because their higher yields more than compensate for the extra risk, Fitterer said. BBB is two steps above the high end of the junk, or high-risk, ratings.
Municipal bonds lost 4.52 percent in the fourth quarter, the largest quarterly loss since 1994, according to the Bank of America Merrill Lynch Municipal Master Index. The bonds lost an additional 2.49 percent this year through Jan. 17. Fitterer’s fund fell 3.34 percent and 1.76 percent in those periods.
Over the past nine weeks, investors withdrew a net $22.7 billion from municipal-bond funds, according to the Investment Company Institute, a Washington-based trade group.
There was more bad news for the municipal market last week when the New Jersey Economic Development Authority scaled back a bond offering in response to weak demand after Governor Chris Christie said health-care spending “will bankrupt” the state unless it requires workers to pay more for medical coverage.
Vanguard Group Inc. of Valley Forge, Pennsylvania, the world’s largest mutual-fund company, canceled plans to open three municipal-bond index funds amid concern that state finances may deteriorate.
Whitney didn’t respond to phone and e-mail messages.
Jamie Dimon, chief executive officer of JPMorgan Chase & Co., said this month he expects more U.S. municipalities to declare bankruptcy and urged caution when investing in the $2.9 trillion public-debt market. JPMorgan, based in New York, is the second-largest U.S. bank by assets.
Liberty Mutual Holding Co., a Boston-based insurer, reduced its holdings of municipal debt of Connecticut, California and Illinois, Chief Executive Officer Edmund “Ted” Kelly said at a Jan. 11 conference. “The market is being held up to some extent by the belief that the federal government will bail out” state and local issuers, he said.
Fitterer said the “positives” in the municipal-bond story are being ignored. Chief among them: rising tax receipts.
Tax revenue for states increased 4.8 percent in the three months through September, the third-straight quarter of gains, the Census Bureau said in December. Property-tax receipts, which mainly benefit local governments, increased 7.8 percent.
Cities and towns have boosted property-tax rates to offset the decline in home prices, Fitterer said. While acknowledging that “there is a lot more work to be done,” he said states are taking steps to shrink deficits.
Illinois lawmakers Jan. 12 passed a 67 percent income-tax increase, the largest in the state’s history, to help close a $13 billion budget deficit. California Governor Jerry Brown proposed $12.5 billion in spending cuts and $12 billion in revenue increases to plug the hole in that state’s budget.
Illinois remains “the poster child” for underfunded pensions, Fitterer said.
Fix for Pensions
The state had assets to pay for about half its benefits last year, the lowest ratio among the states, according to data compiled by Bloomberg. Fewer than half the 50 state retirement systems had assets to pay for 80 percent of promised benefits in their 2009 fiscal years. Actuaries say that ratio shouldn’t be less than 80 percent.
A decade of poor stock-market returns has hurt public pension plans, said Fitterer. “Two years from now we could wake up and the story may look different,” he said.
States and cities can trim future pension costs by switching new workers to 401(k)-style plans, which limit the government’s obligations, said Fitterer.
His fund added to holdings of Illinois and California general-obligation bonds in the fourth quarter as concerns that the states’ fiscal health will weaken pushed up yields, Fitterer said. The extra yield that buyers want for 10-year California bonds compared with top-rated municipal bonds peaked at 134 basis points in the fourth quarter, Bloomberg Fair Market Value data show. The top spread for Illinois bonds was 86 basis points. A basis point is 0.01 percentage point.
Fitterer has also invested in both states through what he calls “backdoor plays,” bonds issued by entities other than the government that provide greater protection for investors.
The fund owns bonds from the Norwalk-La Mirada Unified School District in California because school debt in California must legally be paid before the state’s, Fitterer said. In Illinois, the fund holds bonds of the Metropolitan Pier & Exposition Authority, which are backed by sales-tax receipts.
“If the state were to file bankruptcy, I have a bond with a dedicated revenue stream,” Fitterer said.
Fear of defaults has driven down prices of municipal bonds that have nothing to do with state or local governments, including tax-exempt bonds linked to corporate credit, Fitterer said. He cites as an example bonds the fund owns issued by the Indianapolis Airport Authority, which are backed by Memphis, Tennessee-based Federal Express Corp., the second-largest U.S. package-shipping company.
The 4.34 percent yield on the BBB rated bond is as good or better than the yield available on a similarly rated corporate bond, Fitterer said. As a bonus, investors are getting a tax break. Municipal bonds are generally exempt from federal taxes as well as state and local levies for residents in most states where they’re issued.
Corporate tax-exempt bonds represent 14 percent of his fund, Fitterer said.
The tax-exempt market is dominated by individual investors seeking income-tax breaks. Households own more than $1 trillion in municipal bonds directly, while almost $1 trillion more is held in mutual funds, according to the Federal Reserve Board.
Fear is driving bondholders to sell at a time when valuations are most attractive, Fitterer said.
“Two years from now, when municipal-credit conditions are better and there is less money to be made, everyone will want to buy.”
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