AMODEO & DIMELLA: INVESTING IN MUNI BONDS – Transcript 2/14/2014 #1034

February 26, 2014

CONSUELO MACK: This week on WealthTrack, negative headlines might have investors convinced that municipal bonds are a slippery slope, but this week’s guests say there are many opportunities to be found. Western Asset Management’s Rob Amodeo and Mackay Municipal Managers’ Bob DiMella carve their way to muni bond gold on the next Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Many Americans are going to be shocked on April 15th when they add up their taxes for last year. Federal taxes have gone up, as have many tax bills from local governments. Meanwhile the municipal bond market, long the go to tax shelter for individual investors because of muni bonds’ tax free interest and their historical safety, has been rocked by a series of problems. Among the biggest and most troubling recently: Detroit’s bankruptcy, Chicago’s credit downgrade, and Puerto Rico’s difficulties in refinancing its debt. Now, Puerto Rico is an especially big deal. Its $70 billion worth of debt outstanding, second only to California and New York, is widely held because its bond interest is triple tax free to investors across the country. Investors have been leaving the municipal bond market since the financial crisis for several other reasons as well. Major municipal bond insurers like MBIA and AMBAC ran into financial difficulties, leading to a 98% decrease in the insured muni bond market. State and local governments came under financial pressure and there was a widely publicized prediction of widespread defaults, which did not happen.


This week’s WealthTrack guests are two municipal bond pros who believe there are opportunities to be found in the market. Robert Amodeo is head of municipals at Western Asset Management where he oversees about $30 billion of muni portfolios. He also co-manages several of its muni funds including Western Asset Managed Municipals Fund and Western Asset Municipal High Income Fund which are among the best performers in their category for the decade. Western’s muni team was named U.S. Fixed Income Municipal Manager of the Year for 2011 by Institutional Investor magazine.


Robert DiMella is co-head of Mackay Municipal Managers where he oversees more than $7 billion of muni assets. DiMella and his team run five municipal bond funds under the MainStay name, including MainStay Tax Free Bond Fund which is ranked four stars by Morningstar and the five star rated MainStay High Yield Municipal Bond Fund. Barron’s ranked MainStay Funds among their “top 5” in the tax-exempt category in 2012. MainStay is a WealthTrack sponsor but Bob is definitely here on his own merits.


I started the interview by asking them for an update on the health of the municipal bond market.


ROBERT DIMELLA : The municipal marketplace actually is in a much better shape today than it has been in several years. State and local municipalities have been working very aggressively at their structural imbalances. You know, long gone are the days like three or four years ago when everybody was talking about the bankruptcies. So we actually are very positive and constructive on the marketplace. We actually believe it’s one of the most attractively priced fixed income areas for clients to think about when they’re rebalanced in their entire fixed income portfolios.


CONSUELO MACK: Okay, your take on the state of municipal finances right now.


ROBERT AMODEO : It’s a very similar view. The fundamentals are much stronger today than where they stood just a few years ago. Tax receipts coming in stronger, 15 straight quarters now of improved tax receipts.


CONSUELO MACK: That’s great.


ROBERT AMODEO : Modest spending at the state level. I would offer a bit of caution, though. The improvement in revenue collection is uneven. It’s uneven across regions and especially when you compare states to locals. Locals, predominantly their source of revenue comes from property tax receipts, and they remain somewhat lackluster, especially…


CONSUELO MACK: So these are towns, cities. Right.


ROBERT AMODEO : Towns and villages and smaller communities, and that’s opposed versus, say, strong sales, personal and corporate tax receipts. So there is some caution out there.


CONSUELO MACK: All right, so of course there are the headlines, and we are reading about Detroit bankruptcy. We’re reading about Puerto Rican problems. We’re reading about now Chicago possibly on the problem list. So let’s talk about the headliners.


ROBERT DIMELLA : We believe they’re outliers. If you look at Puerto Rico, if you look at Detroit and a lot of the other situations that have been developing over the last several years, they’re isolated cases. These are problems that have been building for many, many years…


CONSUELO MACK: Decades. Right.


ROBERT DIMELLA :… that are basically coming to roost. Now you’ve got to figure it out. A lot of people were trying to blame it on the financial crisis of 2008. That’s not the case. It may have exacerbated the problem to a degree without question, but those are the isolated cases, and that’s why we kind of have been talking to our client and kind of taking them through this whole process, but it’s the municipal marketplace. This is people’s sleep safe at night money. This is not where they take risk on in their portfolios. So any type of headline risk like those, Detroits, Puerto Ricos, Chicago, Illinois really causes a lot of concern and tensions and anxiety for clients, and so it does have an impact on our marketplace, and we just try to take them through as to we’ll manage that well, because like volatility in all marketplaces, that could be an opportunity for you.


CONSUELO MACK: So talk to us about specifically which of the three that I mentioned, Puerto Rico, Detroit, and Chicago, which of those three are uppermost on your worry list.

ROBERT AMODEO : Well, first would be Detroit because they’re already in bankruptcy, and so that’s an ongoing court battle, and even after the settlement and the decision making, there’s going to be additional court challenges thereafter.


CONSUELO MACK: And so let me ask you about Detroit, actually both of you about Detroit, because there was a legal decision that basically general obligation bonds, which I grew up thinking that those were the safest of all municipal bonds backed by the full faith and credit of the issuer, that in fact that they’re not necessarily going to be the top creditor. So what do we make of that decision? Rob, you first and then Bob.


ROBERT AMODEO : Yeah, there’s a key point there, and there’s a change in the rank between general obligation debt or potential change in rank between general obligation debt and revenue bonds, especially when you look at Detroit. There’s secured and unsecured debt, and at the core of that decision will be how each fare. So far the unsecured debt which included other post-employment benefits, pension obligations, certificate of participations which was borrowings that were deposited into the pension systems, and along with some general obligation debt which is not backed by state aid. Then you have secured debt. You have state aid, back GO debt, and you have water and sewer bonds.


CONSUELO MACK: Right. GO, again, general obligation.


ROBERT AMODEO : Secured bonds are likely to fare better than the unsecured bonds, and the unsecured bonds being that they include general obligation debt have investors fearful that GO debt is not as secure as they once thought.


CONSUELO MACK: So is this a precedent-setting decision? I mean, is this going to be a problem when all of us from now on look at general obligation municipal debt and say it’s not so safe anymore?


ROBERT DIMELLA : It’s an important case study without question. As Rob had mentioned, there’s a lot of different nuances to the Detroit situation that has to go through the court process. As a bondholder, mind you, we actually wanted them to go into bankruptcy court, take it out of the political arena, because there has been precedents set in the court systems, but this is why it’s very important to really understand and know what you own in the municipal marketplace. This is no longer your mom and pop’s type of municipal marketplace. There’s credits, concerns and nuances to the space. For instance, you have to look at every state’s individual constitution. They’re sovereign entities. Michigan is written in a certain way where it’s priority lien on general obligation debt. For instance, there’s two different kinds of general obligation debt. There’s unlimited tax when you can tax as much as you possibly can to pay off the debt and then there’s limited. So you ca get into a problem if it’s limited. You can no longer raise the mill rate to help you pay off the debt under those type of circumstances. So you really have to look at it, and that’s what we do at MainStay. You look for the pinhole risk, and where do the real opportunities lie.


CONSUELO MACK: The pinhole risk. What does that mean?


ROBERT DIMELLA : The pinhole risk is whatever situation you’re looking at is your worst case scenario. How can I possibly lose money in the worst possible light and protect yourself when you’re investing in that light. Puerto Rico is one of them. We’re thinking, okay, if the certain situation gets that severe, what credits do we think are going to be superior to others in order to protect your clients and their money, and that’s what we mean by like your real downside risk with investing.


CONSUELO MACK: Right. So let me ask you about Puerto Rico, because I know that in MainStay, and I’m going to ask Rob the same question is, at MainStay, though, you decided in 2012 to go to zero Puerto Rican debt. Right?




CONSUELO MACK: And the reason for that was …


ROBERT DIMELLA : If you look at the fundamental credit with the Puerto Rico environment, the territory, they’re heavily, heavily indebted. They’ve been under a recession since 2006, 14, 15 percent unemployment, pension scheme that’s running out of money relatively soon if they don’t do anything. In addition to that, you have population that’s leaving the island. That’s never a good mix, declining economy and people leaving the island. You need revenues. You need economic growth and tax collection revenues to help them with the debt load. It’s a very, very high debt load. So they’re …


CONSUELO MACK: Okay, so you decided we just want to be out, because it’s too risky in general.


ROBERT DIMELLA : Absolutely.


CONSUELO MACK: Out of all Puerto Rican debt. You, Rob, on the other hand at Western Asset Management, decided that there were certain types of Puerto Rican debt that you were willing to hold and you thought had opportunity. Tell us about that.


ROBERT AMODEO : Yeah, so there’s some sales tax backed bonds. They’re called COFINA. It’s a Spanish acronym. When you look at the source of revenue that’s supporting this debt, about last year even with the economy there in its eighth year of recession, unemployment rate of 14%, low participation rate when you look at who’s actually working, a high demand for social services …


CONSUELO MACK: It’s a basket case. Puerto Rico is a basket case. Right?


ROBERT AMODEO : You say, “Oh my gosh. This is terrible.” Well, when you look at the revenue streams supporting these COFINA bonds, it’s $1.3 billion in tax collections, just sales tax collections. The debt service equals about 600 million per year, so to date sufficient capital to pay off this debt and service this debt, and that’s despite the fact that when you visit Puerto Rico and you spend one dollar worth of sales tax, on average 50 cents gets to the state. The rest of it goes missing. So if you improve revenue and collection process, and the Governor Padilla and his administration is improving that, you expand the tax base. You increase taxes. There will be more tax revenue to support this debt.


CONSUELO MACK: So it’s worth taking the risk. I don’t know, how is the investment done so far?


ROBERT AMODEO : Yeah, during 2013 it hurt performance no doubt. It hurt performance in our portfolios. So far this year it’s been one of the best performing sectors in the municipal bond market.


CONSUELO MACK: So there is the Warren Buffett, basically it’s the fear and greed, and when there is fear, that’s the buying opportunity. So why did you not decide to use that approach in buy when others are fearful?


ROBERT DIMELLA : You’re absolutely right. So we did actually. So we started entering the Puerto Rico space but only those bonds that have shorter maturities and they’re wrapped by the monoline insurance companies, so they’re double barreled, so to speak, so Assured Guaranty and National Re. We felt that was a very compelling case to buy very attractive yields in addition to total return opportunities in October of last year. So we were out for almost a year and a half, and so you’re absolutely right. The volatility and the fear does generate opportunities. Do we think we’re at the trough in that cycle? No, there’s a lot more noise. In our opinion, there’s a lot more noise and news coming from Puerto Rico.


CONSUELO MACK: Out of Puerto Rico


CONSUELO MACK: So Rob, tell us about what your assessment is of the opportunities in the municipal bond market and how you’re approaching it.


ROBERT AMODEO : There are plenty of opportunities in the municipal bond market, and these high-profile credit stresses we’ve been discussing have truly overshadowed the more important municipal story which is fundamentals continue to improve, and valuations continue to cheapen. As retail investors, these ongoing negative cash flows that we witnessed out of mutual funds last year drove valuations to very cheap levels and stretched them well beyond any fundamentals.


CONSUELO MACK: So opportunities were created by investors fleeing the market.


ROBERT AMODEO : Yes, and so we held on to our investment themes and strategies which include favoring revenue bonds versus general obligation debt, more specifically within the revenue bond sectors. We like corporate-backed obligations, health care. We like transportation-related projects including marine ports, bridges and tolls and so forth.


CONSUELO MACK: And just explain, because some of our viewers might not know what revenue bonds are. So their interest gets paid from…


ROBERT AMODEO : From a specific project which very often is not subject to some political decision making or some politician running for office. It’s a water and sewer system. It’s a toll road. It may be a health care organization. It’s a variety of projects. Be mindful that the municipal bond market, the purpose of the municipal bond market is to fund the most sophisticated public works system in the world, infrastructure, and we all know that we need to rebuild, retook and repair our infrastructure.


CONSUELO MACK: So are we going to see more specific revenue projects and more bonds being issued that … again, I guess you’ve got to look at each individual issue and determine whether it’s an ongoing concern, it’s a well-run project. Right?


ROBERT AMODEO : Yeah, and we’re looking for opportunities. I think P3s, private-public partnerships is an important area in our marketplace. It’s just beginning to take root, but it’s growing in its importance, and that’s a combination of private money and public money funding a road project or funding perhaps some type of construction project like a desalinization plant or perhaps a nitrogen-based fertilize plant in Iowa, and so what we’re doing is we’re finding these opportunities, and they’re at very cheap levels, and we’re buying municipal bonds cheap to six percent municipal yield, and when you tax adjust that, it’s a very attractive level.


CONSUELO MACK: So what Rob’s talking about is that prices have gotten a lot cheaper, so what are your strategies? Where are you finding the best opportunities?


ROBERT DIMELLA : Well, that’s actually a main point as to why we’re telling clients if you looked last year, we put insights together every year. Last year we said the credit cycle troughed the year before and we’re on positive footings now. It was pretty early for that call last year. People were still fearful of what’s going on with the municipal marketplace.


CONSUELO MACK: So when you’re talking about the credit cycle. What do you mean by that?


ROBERT DIMELLA : Credit cycle meaning the fiscal situation at the state and local levels. How dire is their situation? They were having difficult times with the economic crisis of 2008. Revenue collections basically fell rapidly, but if you think about municipalities and why it was such a big concern, their expenses don’t move. Right? So revenues dropped. So got this mismatched, Right? So their structural imbalances they really had to work at. They worked at that, and last year at the beginning of the year, our marketplace was still worried about it. We told our clients, “Don’t worry about it at the state level.” Now this year it’s a little different. We’re actually saying, “Don’t worry about it at the local level either,” because states have done such a good job of managing their situations. One of the ways they did that was pulled state aid from local municipalities. This year they’re putting that back in. So one of the big themes that we’re talking to clients about is that when you’re looking at a fixed income portfolio specifically, after-tax returns are really important. What was negative last year, the negative technicals, the heavy selling, we believe reverses and is very strong and positive this year. Well, the fundamental credits, the economy and tax collection revenues were already positive, and you were taking away the big negative from last year, and it’s going positive. Baby boomers are retiring. The need for income is very, very important. Taxes are going higher. Federal, state and local is going higher, so demand is going to be very strong. Supply is more than manageable. As Rob had mentioned, P3s are very important. They’re important for many different ways.


CONSUELO MACK: The P3s again are the public-private partnerships.


ROBERT DIMELLA : Public-private partnerships.


CONSUELO MACK: And do you have an example of what… ?


ROBERT DIMELLA : So why are these important? Well, you had two in the greater New York City area recently and that is for the Goethals Bridge replacement and the Tappan Zee Bridge replacement. What it does is there’s massive need for capital for this infrastructure. It’s not all coming from municipal tax-exempt debt. It’s going to come from private entities as well. So there’s equity tranches, private debt and public debt. It’s not all coming from the tax-exempt marketplace, so even though infrastructure needs all this reinvestment going forward, it’s not going to balloon with debt from the municipal marketplace. That’s the positive sign of P3s that’s going to continue. Infrastructure is a great investment strategy, but investing in infrastructure in the United States is in its infancy. You know, Canadian investors, European investors, Australian investors, they get it. They’ve been doing this for a very long period of time. It’s kind of new to our marketplace, so we believe that is going to really re-price the municipal marketplace for clients in 2014, and how you position your portfolios to fully take advantage of that is very, very important.


CONSUELO MACK: So that’s so interesting. Rob, do you agree, number one, that there are tremendous opportunities in these infrastructure projects, and that we’re going to see a lot more debt issuance that you think would meet your criteria for investing?


ROBERT AMODEO : Yeah, as I mentioned it’s a key part of our investment strategy. You have to be careful, though, especially with particular projects, I mean, toll roads for example. They’re notorious for having a high amount of leverage and projecting the traffic that well exceeds any sense, and then their ability, the pricing power. So just be careful in terms of the fundamentals. Look at it and look closely at it and pick your projects well.


CONSUELO MACK: You also mentioned something, that was fascinating, to do with fracking at one point. So tell us about that, some of the new projects.


ROBERT AMODEO : Yeah, so fracking, for example, is changing the dynamics in the energy sector, and what that may do is allow high-tech manufacturers to receive the natural gas at perhaps a lower price. What we have within the municipal bond market in Iowa, there’s a nitrogen-based fertilizer plant being built, and what they’re doing is driving a pipeline into this factory where they then will produce nitrogen-based fertilizer hopefully at a lower price than the local farmers can get in the world markets. So here you have an example of how that new dynamic in the energy sector may promote some opportunities for public finance investing.


CONSUELO MACK: So what about the interest rate cycle? How is that going to affect us?


ROBERT AMODEO : You know, the retail investor has been reading literature for the last few years about the great rotation out of bonds into equities, and last year it was almost a negative demand cycle. It was very difficult to break. The retail investor which dominates demand from municipal securities were selling municipal bonds and so the municipal market ended 2013 at a level not only at a level of rates but also credit spreads that was quite generous.


CONSUELO MACK: Generous in your world, that’s good. That’s an opportunity, but for those who are holding those bonds, it’s terrible because the prices have gone down.


ROBERT DIMELLA : Well, that’s why it’s important to talk to their clients. Right? As you point out, you actually made a great point. You said, “Well, everybody got out of bonds regardless of what bonds they were and regardless of what price those bonds were trading at.” Well, that doesn’t make any sense just like equities. There’s relative value differences, right? So we actually believe the way the municipal bond market is priced today actually insulates you to a fair degree from a rising rate environment. You want to take on any type of duration or, quite honestly, credit risk that’s in fixed income portfolio. We believe it should come more from the municipal side of the equation because of the damage from last year. You’re absolutely right. Volatility breeds.


CONSUELO MACK: Oh, that’s interesting.


ROBERT DIMELLA : And if you look at it not only on an after-tax basis but a pretax basis, it’s very, very compelling. Look at where a lot of volatility is. Right? High yield and municipal space is very attractive. You know, historically municipal high yield on a yield basis versus taxable high yield trades around 75 to 80% ratio. We’re tax exempt, so we should be trading below. Right? Today it’s 120%, so regardless of what tax bracket your client is in, they’re picking up income. This is why there’s a lot of non-traditional buyers, crossover buyers, people who aren’t subject to U.S. taxes buying municipal bonds.


CONSUELO MACK: Rob, as far as the high-yield space and aside from revenue bonds, for instance, are there areas that you are finding as well that are really generously priced as you would put it?


ROBERT AMODEO : Yeah, I would say more specifically single A, triple B securities, even below investment grade securities are offering a generous yield.


CONSUELO MACK: Again, that would be high yield.


ROBERT AMODEO : It would be high yield or below investment grade. Yes, and that’s going to offset potential for negative price action even if you have the view that rates are going to rise. It will offset some of that risk there. I would say within the general obligation sector we’re favoring the states and the higher quality local governments. We think that those bonds could weather a wider range of economic scenarios versus those lower quality local governments that have low financial flexibility and more vulnerable to potentially the federal government cutting back their sharing with revenue, and as we see even within Michigan, say, for example, a state that has a nice surplus, there are problems at the local level, and the state is reluctant to share revenue with the local governments until it’s at the point of bankruptcy.


CONSUELO MACK: Right. So it’s time for the One Investment for a long-term diversified portfolio if you can believe it, so what would yours be, Bob DiMella?


ROBERT DIMELLA : You know, it’s interesting because Rob pointed out to this, we think actually infrastructure investing is very important. If you think about long-term diversified investing for clients, not a short-term strategy, these type of assets are long life, consistent cash flows, inflation protection if you’re talking about toll roads and airports. Desalinization plants is another one. We actually think infrastructure is a very solid, good idea that clients should really think about when rebalancing their portfolios to take advantage of long like secular moves as we reinvest in all of the infrastructure throughout the United States. We believe that is going to fare very well for clients.


CONSUELO MACK: So Rob Amodeo, what is your One Investment for a long-term diversified portfolio?


ROBERT AMODEO : I would look to the stock market for a well-diversified portfolio. Obviously, municipal bonds are a big part of that, but on the stock side it would be the pharmaceutical companies, perhaps a basket of pharmaceutical companies like a J&J, a Merck or an Amgen. It looks like there’s a pipeline of interesting products, innovative products coming out of that sector, and there’s some good dividend yields there, too. So the growth prospects along with the dividend yields and interesting products as a combination with, say, fixed income in particular municipal bonds.


CONSUELO MACK: So Rob Amodeo, it’s so great to have you again on WealthTrack. Thanks so much for being here. And Bob DiMella, a first-time guest, thank you as well for joining us on WealthTrack.


ROBERT DIMELLA : Thank you for having me.


ROBERT AMODEO : My pleasure.


CONSUELO MACK: At the close of every WealthTrack, we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is a natural follow up to the discussion we just had. It is: Consider owning municipal bond funds.


Despite the recent negative headlines, munis rarely default on their interest payments, they offer you tax free interest, their yields right now are competitive with those of taxable bonds. Usually muni yields are lower than equivalently rated corporate bonds. Munis offer diversification in your portfolio. They are known as a non-correlated asset meaning they don’t move in lockstep with other types of investments such as stocks and in their case other types of bonds. And this is one of those asset classes where you are better off in an actively managed fund because selectivity really counts. Among the other funds highly rated by Morningstar are several run by Fidelity, including the Fidelity Intermediate Municipal Income Fund.


I hope you can join us next week our guest will be recent Noble Prize winner- Yale economics professor Robert Shiller- who will discuss the current state of the stock and housing markets. Where does he see signs of market bubbles developing now?


In the meantime to see past shows and additional insights from our guests done exclusively for our Extra feature, please go to And for those of you on Facebook and Twitter we look forward to connecting with you. Have a happy Valentine’s Day and President’s Day weekend and make the week ahead a profitable and a productive one.


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