A bond’s-eye view of the world
- Chad Rach
- Portfolio manager/investment analyst
- Based in:
- Los Angeles
- Investment experience:
CHAD RACH: It wasn’t too long ago, about 18 months or so, when munis were kind of a dirty word. They were tarred and feathered, and starting in the fourth quarter of 2010, they really produced some pretty negative results. There are lots of reasons for that — one of which, I think, was a pretty obvious one. There was a Meredith Whitney effect, if you will, on the market. But when I step back and look at where the market stood in the first quarter of 2011, it looked like some really strong building blocks for muni results going forward — great building blocks for some pretty strong performance. And we got it. Long-term funds like [The] Tax-Exempt Bond Fund [of America]® produced results in the 10% or so range in 2011. We’re barely through July here, and we’re up another 7% or so. Some pretty strong returns.
But what I’d like to talk about — and this may be a bit more controversial or off the mainstream — is where those results actually came from. Some of the press reports that I’ve been reading in the last couple months are really describing it in terms of “Well, investors have changed their view and now are [having] more of a love affair with munis and feel comfortable with muni credit,” so that’s why we got 10% and another 7% or so this year. And I would argue that’s really not the case, or at least in large part not where the results came from. If [it] were, I think, you would have seen a couple of things. I think you would have seen governmental credit spreads in the double-A and single-A range tighten in dramatically. We’ve got some examples of that happening, but by and large that really hasn’t been the case.
We would also have seen those ratios that I was talking about — the triple-A munis relative to Treasuries — tighten in dramatically or grind down back into the 80% or so range in the 10-year spot. And actually, what we’ve seen is today, 10-year triple-A munis relative to Treasuries are higher than they were going back to those dark, post-Meredith Whitney days. So that’s really not the reason. It’s hard to build an argument to say that investors just love munis now and are comfortable with credit risk there.
What I think the real answer is — or the large part of the answer is — recognition that we’ve just gone through a massive rally in the Treasury market. I believe we peaked out in the last 18 months in 10-year Treasuries at 3.75% or so, and today we’re sitting in the low 1.40s or so. So, [a] massive rally in the market. And if you marry a massive rally in the Treasury market with a long-duration asset class like munis — like The Tax-Exempt Bond Fund and [its] peers — I think you can really develop the spectacular results that we saw, purely based on the duration aspect.
The Tax-Exempt Bond Fund is a relatively long fund, and [its] peers are relatively long. But it may not be so obvious to everyone that the overall peer group might be two, maybe even three years longer on a duration basis than many of its taxable equivalent peers. Again, you marry this nice concoction of long duration and a big bond rally, and you can get some spectacular results.
But what that also tells me is we have to remember that the long-duration asset class performs really poorly in the event that interest rates go up a lot. So we could easily tell a story, if you will, of funds like Tax-Exempt Bond Fund being down a fair amount, even with a pretty positive environment for munis, just simply due to the duration effect.