Municipal Bonds Continue Rally Despite Uptick in Taxable Yields

 

Q1 | 2012 »  Q&A

Municipal bonds continue rally despite uptick in taxable yields Thalia Meehan, Meehan , CFA CFA Portfolio Manager

Portfolio management team Thalia Meehan leads a team of veteran investors responsible for day-to-day management of the fund.

Key takeaways

Yields declined slightly in the muni market, reflecting some spread tightening Yields

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versus Treasuries. Issuance remained Issuance remaine d light while demand from retail investors continued to be strong.

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Despite an uptick in defaults, the fiscal backdrop for municipalities continues continues to gradually improve along with the broader broade r economy. The funds continue to underweight local The loca l general obligation obligati on bonds in favor of

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Paul M. Drury,CFA

Susan A. McCormack,CFA

(industry since 1989)

(industry since 1986)

essential-service revenue bonds, and maintain their tilt toward above-benchmark above-benchmark credit exposure. Municipal bonds posted gains gai ns in the first quarter. qua rter. What was driving those returns?

Yields in the municipal bond market continued continue d to decline in the first quarter, despite an uptick in yields in Treasuries. This was in part the result of a perceived shortage in supply. January and February tend to be light issuance months on a seasonal basis, and although the issuance in the first quarter of 2012 was slightly higher than it was one year ago, the new issue is sue rate remains below the longer-term longe r-term average for this time ti me of year. Later in the quarter, credits spreads versus Treasuries tightened tightene d somewhat, and that helped boost returns for municipal bonds in general. In addition, we continued to see strong demand from investors, with high flows into municipal bond mutual funds, which created a solid technical environment for our portfolios.

PUTNAM INVESTMENTS | putnam.com

 

Q1 2012 | Municipal bonds continue rally despite uptick in taxable yields

In 2011, defaults in the municipal bond market

Discussion surrounding surroundin g tax rates has also

rose markedly versus 2010, although they t hey

captured headlines lately, with some parties

remained low overall. What caused that

calling for higher top rates and others

increase?

suggesting a flatter, lower tax structure.

Since 2008, defaults in the municipal bond market have

What effect do income in come tax rates have on the

been trending lower, with most of the defaults default s stemming

municipal bond market in general?

from lower-rated or unrated securities, often of ten in more

Income tax rates definitely matter to individual investors,

speculative real-estate-backed sectors of the market. In the fourth quarter quar ter of 2011, however, we saw a significant

and at the margin, higher tax rates are generally positive for municipal bonds, as demand dema nd tends to be higher. higher.

uptick in the default rate, driven by three high-profile

But income tax rates are only one factor fa ctor among many,

events.

including the prevailing interest-rate environment, the

The first was the bankruptcy filing of American Airlines. With about $3 billion of par-value bonds in the municipal market, the filing had a significant effect on the level of

strength of the equity markets, and the tax picture more broadly — for example, the potential for tax deductions in any given year.

defaults. The second s econd was a default by Jefferson County,

Once this year’s elections have taken place, we believe

Alabama, a county whose fiscal struggles had captured

there will be a much broader discussion disc ussion on tax reform in

headlines for a number of years. The county’s bonds

2013. There are a number of issues that will need to be

had been trading at distressed levels for some time, and

addressed even before then, including the debt ceiling,

their eventual default in 2011 was well anticipated anticipate d by the market. The third was a subset of tobacco bonds that th at

the alternative minimum tax, and the fate of the Bushera tax cuts, cuts , which are slated to expire at the end of the

tapped into reserve reser ve funds to make a coupon payment

year. As always, we’re monitoring the situation closely.

during the fourth quarter. quarte r. Although no payments were missed, the action ac tion technically constituted constituted a default,

How attractively valued are municipal bonds

which added to the market total for 2011. Overall, the

versus Treasuries?

default rate remained remaine d relatively low for all of last year,

While I would caution that it’s important not to put

finishing at well below 1%, and looking ahead we believe

too much credence in any single indicator, indic ator, muni yields

defaultss will continue to be in line with historical averdefault

relative to Treasurie Treasuriess is one metric for gauging the

ages. That said, it’s it ’s likely that that certain cities or counties

attractiveness of municipal bonds broadly broadly.. AA A-rated

will continue to capture capture headlines in 2012, as a number

municipal bonds appear slightly undervalued relative

of municipalities municipalitie s continue to work to find their fiscal

to their long-term averages, while A- and BBB-rated

footing.

securities securiti es appear to us to offer even more compelling valuations.

PUTNAM INVESTMENTS | putnam.com

 

Q1 2012 | Municipal bonds continue rally despite uptick in taxable yields

How are you positioning the portfolios portfoli os from a

What is your outlook for the remainder of 2012?

sector and credit quality quali ty perspective?

We believe that the fiscal conditions of states and

We’ve We’v e been focusing primarily on essential service

municipalities are showing signs of improvement, but

revenue bonds, which we believe are more insulated

that states will continue to face financial challenges as

from fiscal pressures pressure s at the municipal level. From a credit

the economic recovery works to gain some traction.

quality perspective, as I mentioned, we believe the BBB

Tax receipts are beginning beginn ing to increase, albeit slowly,

segment of the market offers some attractive values

and we believe actual defaults default s will remain relatively low.

and the potential for further spread tightening. Colleges

Our primary concerns remain focused focuse d on the broad

and universities, utilities, toll roads, and health care are

economy and Congress’s plans to reduce the deficit.

some of the sectors sec tors we’re we’re finding opportunities in, and

Broad-based tax reform, a change in the tax status of

we believe the fundamentals in these areas of the market

municipal bonds, or significant cuts in state funding f unding

have been gradually improving along with the broader

all would have consequences for the municipal bond

economy.

market. We are monitoring all of these factors fac tors closely,

Conversely, we continue to be underweight local general obligation, or “G.O.,” bonds, not so much because of default fears, but because be cause we continue to see funding stresses in the system. With fewer federal dollars flowing to the states and, in turn, fewer state-level dollars being transferred to the local level, local G.O.s are coming under increased funding pressures, which can translate into downgrade risks and increased price volatility. volatilit y. Moreover, local municipalities municipalitie s tend to rely more more on property taxes for funding, and with home prices still struggling strugglin g to find a bottom, that source of income has been less reliable in the past few years.

PUTNAM INVESTMENTS | putnam.com

and believe our funds are well positioned for this lessthan-certain environment going forward.

 

Q1 2012 | Municipal bonds continue rally despite uptick in taxable yields

Annualized total return performance as of March 31, 3 1, 2012 Putnam Tax Exempt Income Fund (PTAEX) Class A shares (inception 12/31/76) Last quar ter

Before sales charge

After sales charge

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Barclays Capital Municipal Bond Index 󰀱󰀮󰀷󰀵󰀥

Putnam Tax-Free High Yield Fund (PTHAX) Class A shares (inception 9/20/93) Last quar ter

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Quarterly returns are cumulative.

Current perfor mance may be lower or higher than the quoted past performa nce, which cannot guarantee future result s. Share price, principal value, and return will var y, and you may have a gain or a loss when you sell your shares. Performan ce of class A shares after sal es charge assume s reinvestment of distribution s and does not account for taxes. After-sales-charg e returns reflect a maximum 4.00% load. A 1% short-term trading fee may apply. For Putnam Tax-Free High Yield Fund, the life-of-fund perform ance for class A shares is based on the historical per formance of class B shares (inception: 9/9/85), adjusted for the applicable sales charge . To obtain obtain the most recent month-e nd performance, visit putnam.com. The funds’ expense ratios are based on the most recent prospectus and are subject to change. The Barclays Capital Municipal Bond Index is an unmanaged unmanaged index of long-term fixed-rate investment-gra de tax-exempt bonds. It is not possible to invest directly in an index. Past performa nce is not indicative of future results.

The views and opinions expressed here are those of Thalia Meehan, Me ehan, Portfolio Manager, as of March 31, 2012, are subject to change with market conditions, and are not meant as investment advice. advi ce. 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 cer tain risks including interest-rate 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 interest-rate risk than short-term bonds. Unlike bonds, bond funds fun ds have ongoing fees and expenses. expenses . Lower-rated bonds may offer higher yields in return for more risk.

Request a prospectus or summary prospectus p rospectus from your financial representative or by calling calling 1-800-225-1581. 1-800 -225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. Putnam Retail Management | One Post Office Square | Boston, MA 02109 | putnam.com

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