(May 2012) I recently had the pleasure of speaking with Portfolio Manager and Head of Municipal Bonds for Western Asset, Robert Amodeo. I asked Robert how he goes about finding value in the Municipal Bond market, and here is what he said:
During our interview Robert stressed the level of granularity in which Western Asset uses to make investment decisions. For example, Robert and his team might like hospital bonds with 8 to 10 year maturities, but not like the same bonds with 7 year maturities. Essentially they focus a large amount of energy on finding pockets of opportunity where they believe there’s value. To find these opportunities, they look at historical yield relationships between different sectors (i.e., hospital bonds, water and sewer projects) in order to find “cheap” sectors.
Within each sector, they look at the yield curve. In addition to looking at the average or median yields, they are very interested in the range of yields for a particular maturity date. This will enable them to determine if there are several bond issues within a sector, with a particular maturity date, that pay significantly more than the average. The Western Asset credit team analyzes these bonds to determine if the additional yield represents a buying opportunity, or accurately reflects the credit risk of the bond.
I asked Robert when these historical relationships need to be re-evaluated. He said that the demise of the monoline insurers (bond insurers) changed how Western Asset used these historical comparisons. Prior to 2008, over 50% of the municipal bond market carried a AAA credit rating as a result of insurance. Following the insurers losing their AAA ratings, the supply of AAA issues sharply decreased and the supply lower rated bonds increased. As a result, there is much more variation in credit quality between issues and sectors over the last 4 years.
A Surprising Remark About Ratings
I asked Robert if he thought the rating agencies now use the same scale for evaluation of municipal and corporate bonds. After saying yes, I continued the line of questioning by asking, “Should a municipal bond and a corporate bond with the same rating have the same default rates?”. To my surprise, he answered “No” that he expected municipal bonds to continue to have lower default rates than corporate bonds. In other words, just because the rating agencies have standardized the way they rate bonds, does not mean that they will behave the same. I guess the power to raise taxes on your citizens to increase revenue is hard to include in a statistical models.