(May 2012) We recently had the pleasure of speaking with Scott Cottier, CFA. Scott is responsible for the day-to-day management of the 20 municipal bond mutual funds in the Rochester Family of Funds, part of Oppenheimer Funds.
We asked Scott where he is currently finding value in the municipal bond market and here is what he said:
1. Rochester Funds Likes Puerto Rican Bonds
Bashing Puerto Rican bonds has become fashionable in the the financial press. In previous articles, Learn Bonds has engaged in this activity as well. However, demand for Puerto Rican bonds is enormous, with the number of orders for new issues greatly outnumbering the available supply of bonds for sale. We have not been able to find anyone however that would articulate an argument in favor of Puerto Rican bonds. That was until we met Scott Cottier.
Here are Scott’s Arguments in Favor of Puerto Rican Bonds:
Puerto Rico Is Curbing Spending & Increasing Revenue
Pension Liabilities Are Not Increasing
New state workers in Puerto Rico will not be receiving a pension. Instead, they will have to save for retirement like a member of the private sector. While Puerto Rico has large pension liabilities, they will not be getting any worse.
Sales Tax Revenue Is Increasing
Until recently, Puerto Rico’s sales tax collection rate was exceptionally low. The current Governor implemented a program which encouraged consumers to make sure their sales tax was being collected by the merchant. Now every receipt that includes sales tax, doubles as a lotto ticket. When you pay sales tax in Puerto Rico and save your receipt, you can now win prizes up to $25,000, so of course more people now ask for their receipt.
The Federal Government Would Step In To Help Puerto Rico
Scott Cottier believes that if Puerto Rico was in a terrible financial crisis that the US Government would step in to help. He suggested that they have several tools at their disposal, short of bailout, to help Puerto Rico. For example, by raising the import tax on rum, there could be hundreds of millions more in revenue per year in the coffers of Puerto Rico.
The combination of Puerto Rico’s improving fiscal policies and the backstop of the federal government is behind Rochester’s analysis that the level of risk is lower than the markets view.
2. High Coupon Municipal Bonds Past Their Call Date Provide Great Opportunity
Many municipal bonds contain a call feature, which allows the issuer to buy their bonds back from investors before they reach maturity. This protects the issuer from being locked into paying a high interest rate, if interest rates fall in the future. As interest rates have fallen dramatically in the last 10 years, the market is expecting issuers who have high interest rate debt which is past its call date, to call the bonds and reissue debt at today’s lower rates. Bonds which are expected to be called currently yield more than bonds where this is not the case.
According to Scott however, issuers do not always call the higher yielding debt as the market is expecting, which presents an opportunity to earn that higher yield for Rochester and their investors. To identify this type of opportunity, they closely track and monitor the historical behavior of issuers, to anticipate when and if they will call their bonds. In doing so they frequently find opportunities to buy bonds that are currently yielding 5% or more, even though the prevailing rate in the market for new issues is closer to 3.8%. If Rochester is wrong and the bond is called, the fund may lose a couple percent on the position. If they are right however, they can earn two or three percentage points of additional interest per year for their investors.
3. Unrated Bonds
Most buyers of municipal bonds are only interested in rated, investment grade bonds. There is relatively little demand for unrated bonds, which require the buyer of the bond to do their own credit research. The lack of demand for these bonds results in their yields as a whole being higher than rated bonds with a similar risk profile. About 43% of the bonds in Rochester’s High Yield Fund is in unrated bonds.
Why is there less demand for these bonds?
The municipal bond market is dominated by “mom and pop” investors who own approximately 2/3rds of the market. These investors generally have strong preferences for the type of municipal bonds that they buy. They want safe bonds with maturities that tend to be less than 10 years. If the bond is unrated, these investors generally don’t want them because they cannot measure the safety.
What type of municipal bonds are unrated?
According to Scott Cottier, they tend to fall into three different categories.
- Sophisticated issuers that expect that if their bond was rated it would be low-investment grade or below. Having a low rating will not provide any value to issuer in the form of lower yields, so there is no point in getting a rating.
- Unsophisticated issuers, that don’t understand the benefits of getting a rating.
- Smaller issues where the cost of getting a rating is greater than the benefit of a lower yield.