(Reuters) - For investors concerned about how much longer the bond rally will run, tax-free U.S. municipal debt is an attractive option.
Tax-free debt has not nearly kept up with the rally in U.S. Treasury bonds during the past few years, making it “one of the last bastions of value in the fixed-income world,” says Troy Willis, senior portfolio manager at OppenheimerFunds.
Willis helps oversee the firm’s stable of 15 state-specific and five national municipal bond funds.
Munis lagged as some states such as Illinois and California encountered well-publicized financial difficulties. Noted banking analyst Meredith Whitney forecast a massive wave of municipal defaults across the country.
None of those disasters happened.
“People are figuring it out,” Willis said. “We keep telling people all that stuff doesn’t matter.”
At the 2013 U.S. Lipper Fund Awards in New York last week, Oppenheimer was named best fixed-income manager among large fund firms, or those with at least $44 billion in assets, by Lipper, a unit of Thomson Reuters Corp.
Many of Oppenheimer’s individual muni funds were also Lipper award winners, including the $3 billion Oppenheimer AMT-Free Municipals Fund. It gained an average of 11.26 percent a year over the past three years, almost double the average annual return of the Barclays Capital U.S. Municipal Bond Index.
Oppenheimer’s municipal team, based in Rochester, New York, focuses most of its time looking for undervalued bonds and sectors. Unlike many other fixed-income shops, little to no time is spent positioning for the next big move in interest rates.
“We don’t spend much time doing interest-rate forecasts,” Willis said. “We don’t think people can do that consistently well.”
He and his colleagues outperformed by loading up on hospital debt and bonds backed by payments from tobacco companies.
Tobacco bonds, backed by revenues linked to the amount of cigarettes sold, fell out of favor as smoking rates declined sharply in 2009 and 2010. As fewer people smoke, cigarette sales decline and there is less revenue to pay off the bonds.
But Oppenheimer managers saw the declines as a one-time blip. Over the last two years, the rate of decline receded to the long time average of about 3 percent. Tobacco bonds rallied, gaining over 30 percent in Oppenheimer portfolios in 2012.
Hospital bonds had been hit by fears Obamacare would cripple their revenues. They recovered strongly last year as it became clearer that bond payments were not in jeopardy.
Looking at the various niches and sectors of the municipal market for 2013, bonds issued by Puerto Rico look particularly appealing, Willis said.
Last fall, Alejandro Garcia Padilla of the Popular Democratic Party defeated incumbent Republican governor Luis Fortuno, who had been working to cut spending and trim the island’s budget deficit.
Investors feared Padilla might be less aggressive. And in December, Moody’s Investor Service cut Puerto Rico’s debt to Baa3, the lowest investment grade rating before junk status.
Yields on the bonds jumped after the election, according to data from Municipal Market data, a unit of Thomson Reuters.
The island’s 10-year debt yielded a full 2.30 percentage points more than a typical triple-A rated 10-year general obligation municipal bond before the vote, but widened to 3.10 points in January. The spread narrowed a bit to 2.85 as of March 12, still the highest among major issuers tracked by MMD.
Willis said the concerns are overblown and the sell-off produced high yields to compensate for the risks.
“It signals another opportunity for us,” he added.
In February, new Governor Padilla approved a deal to privatize Puerto Rico’s main airport and proposed a series of fixes for its underfunded pension plan.
Still, Standard & Poor’s followed Moody’s and downgraded Puerto Rico’s debt this week and analysts warn the island’s finances could continue to deteriorate.
“They have tough times ahead,” said Alan Schankel, managing director of municipal research at Janney Montgomery Scott.
The airport privatization and proposed pension reforms represent progress, but Puerto Rico still has other “huge problems,” particularly its overall weak economy, Schankel added.
Reporting by Aaron Pressman. Editing by Lauren Young and Andre Grenon