profile
Warren D. Pierson, CFA
Senior Portfolio Manager
Baird Advisors and
Baird Funds
About Warren D. Pierson, CFA
Warren Pierson is a Senior Portfolio Manager for Baird Funds and Baird Advisors, Baird’s fixed income asset management business. With nearly 25 years of investment experience managing various types of fixed income portfolios, he plays a lead role in coordinating and implementing all fixed income strategies at Baird and is the lead portfolio manager for the Baird Intermediate Municipal Bond Fund.

profile
B. Craig Elder
Senior Fixed Income Research Analyst
Private Wealth Management Research
About B. Craig Elder
Craig Elder is Baird’s senior analyst providing fixed income market and investment strategy to Baird’s Private Wealth Management group. In addition, he provides credit research support for corporate bonds, municipal bonds and preferred stocks.
Municipal Bonds More Complex Than They Used To Be
Changes Require Investors to Know What They're Buying

The municipal bond market is undergoing some significant, fundamental changes. Traditionally AAA-rated because of insurance coverage, municipal bonds have become much more like corporate bonds, which require you to fully understand the underlying risk before making an investment.

Tim Byrne, Baird’s Director of Private Wealth Management Research, Products and Services, led a discussion on these changes with Warren Pierson, Baird Advisors Senior Portfolio Manager, and Craig Elder, Senior Fixed Income Research Analyst. Here are their thoughts.

Growing Municipal Credit Concerns
Municipal bonds remain high-quality investments, but the investment landscape is more complex and there is more risk than there used to be. While the economy is slowly beginning to recover, problems are starting to surface for municipalities facing decreased tax revenues because of lower home values, high unemployment, lower wages and reduced consumer spending. In addition, municipalities are feeling the pinch from lower state and federal aid. After decades of steadily increasing tax revenues, many municipalities are struggling to balance their budgets and are facing hard-to-fix structural deficits. While the softness in municipal revenues – such as property taxes, sales taxes and income taxes – has taken a year or more to surface, you can expect to see municipalities’ challenges getting more media attention in the future.

Adding to the problem, the three main companies that insured the principal and interest of municipal bonds were severely hurt by their involvement in the structured finance market, raising questions about their ability to back up bonds they’ve insured. In the past, many investors assumed insured bonds were safe, regardless of the issuer. This assumption is clearly no longer valid, and only one insurer is writing new business.

Possible effects from the challenges facing the municipal market include:

  • Lower ratings – Financial challenges and weaker financial positions could result in downgraded ratings – and price declines – for some issues. In 10-year maturities, a downgrade from AA to A could result in a 5% price decline.
     
  • Greater potential for default – Although the probability of widespread default is low, some issuers may not be able to service their debt if revenues continue to decline. The types of bonds that could potentially involve more risk are specific revenue bonds rather than general obligation (GO) bonds, which have municipalities’ full tax base behind them. That said, even some GO issues could be at risk if the issuers face severe financial problems.
     
  • Increased price volatility – The frequency and magnitude of changes to bond prices may increase as the market prices in risk surrounding these issues given the uncertainty and the lack of information.
     
  • Decreased liquidity – Concern over increased risk could limit liquidity in certain areas and raise transaction costs. Smaller issues could be particularly affected.
What Should Investors do?
 
Q: Do you still recommend municipal bonds?
A: Yes, municipal bonds can continue to play a valuable role in an investor’s portfolio. Municipal bond yields in general have held up, and municipal bonds could become more attractive for high-net-worth investors if the 35% top income-tax bracket increases to 39.6%, as it is expected to do in January. Although greater attention to the underlying rating of the bond is now required, municipal bonds remain one of the most attractive of the fixed income asset classes.

Q: What does a drop in credit rating mean to bonds already in my portfolio?
A: If a rating declines, you are likely to see a lower value for that investment in your portfolio. However, if you are planning to hold the bond to maturity, you aren’t likely to be impacted by a lower credit rating unless the issuer defaults. While the risk of default is increasing, it remains relatively low and is expected to remain low for highly rated bonds. We recommend that you discuss your bond portfolio with your Financial Advisor to understand the underlying quality and any risks in your bonds.

Q: How should you choose a municipal bond?
A: While municipal bonds have long been considered a close second to Treasury bonds in terms of credit quality, risks have increased. That means you need to do your homework with your Financial Advisor when selecting one. We recommend closely reviewing the underlying credit rating of the bond and the financial outlook of the issuer. We caution investors against going too far down in credit quality or too far out the yield curve.

Q: How can investors reduce risk?
A: In terms of individual bonds, we recommend those with higher ratings and those supported by the widest revenue base. If you’re creating a portfolio, we currently recommend bond barbells instead of traditional bond ladders. We recommend a barbell strategy with shorter term maturities out to two years and intermediate-term maturities of 10 to 15 years, giving you greater ability to react to potential drops in the market through short-term bonds while also locking in the more attractive rates of intermediate-term bonds.

Many investors may be better served by investing in a municipal bond fund that offers a diversified portfolio of high-quality issues. If you invest in a bond fund, consider the fees before investing and, importantly, do your homework to know what the fund owns.

No matter the fund or bond investment, we strongly urge investors to consider the risks just as you would with an equity or corporate bond investment.

Ultimately, municipal bonds are still a wise investment for many investors, particularly high-net-worth investors looking for federal tax-free income. However, municipal bonds are no longer “set it and forget it” pieces of your portfolio, and you should work with your Baird Financial Advisor to make informed decisions.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. This and other information are found in the prospectus. For a prospectus, contact your Baird Financial Advisor. Please read the prospectus carefully before investing.

Diversification does not ensure a profit or guarantee against loss.

Investors should consider the potential applicability of the alternative minimum tax prior to investing.