STRATEGY INSIGHTS MUNI OPINION Fixed Income OCTOBER 2012 The price of a defensive portfolio Investors are programmed to seek out investments that have low prices. But in the muni world the price of a bond does not necessarily tell you whether you are getting a good deal or not. Recent changes in muni issuance have brought more par priced bonds to the market. Is that a good thing? Depends what you are trying to accomplish. Bond pricing is one of the most misunderstood aspects of municipal bond investing. Many investors often question why they should own bonds that are priced well above par value, when they can go out and buy a different bond priced near par, or even at a discount. Doesn t buying a lowerpriced bond mean you are getting a better value? If your goal is to optimize your long-term total return prospects and manage risk, then the answer is no. A year ago, our advice to investors was simple; buy munis. Almost any muni would do, assuming the bond didn t have credit issues. The ratios of AAA muni yields to U.S. Treasury yields were well over 100%, which signaled very strong relative value for the muni market. 1 In addition, the muni yield curve was unusually steep and credit spreads were wide. 2 Therefore, we advised investors to add risk: move out on the yield curve and take on more credit risk. Since then the yield on 30 year AAA munis has decreased by almost 100 basis points, causing a strong increase in the price of the bonds. 3 In addition, credit spreads have tightened, and the yield curve has flattened. This has reduced the attractiveness of adding above average risk to portfolios. Authors Philip G. Condon, head of municipal bond portfolio management, DWS Investments Ashton P. Goodfield, CFA, head of municipal bond trading, DWS Investments Carol L. Flynn, CFA, head of municipal bond research, DWS Investments Kevin Walsh, CFA, fixed-income product specialist, DWS Investments Investment products: No bank guarantee I Not FDIC insured I May lose value
So what is our advice today, and where do we see the greatest value? In today s market we still think munis are attractive yield ratios vs. Treasuries are still around 100%, the yield curve remains relatively steep, and credit spreads are reasonably wide. But while last year value was easy to spot, today value is less obvious. In the current environment, value involves the structure of the bond the choice of coupon, call date and maturity. High coupon bonds are the greatest value. We especially like premium coupon, 25 year maturity, single-a rated bonds. We ll give an example below of why we prefer this structure. If you are a little more cautious, then single-a rated 8 to 12 year premium coupon bonds are also attractive. For example, the two bonds in Figure 1 were issued recently by the same single-a rated municipal issuer. Both bonds are due in 31 years, both have a call in 10 years. Bond A has a higher coupon and is priced at a significant premium over par, 111.94. Bond B offers a lower coupon and is priced just slightly above par, at 100.90. The lower priced bond, Bond B, was issued at a 3.89% yield to maturity, 32 basis points higher than the 3.57% yield of Bond A. Which has the better total return profile under most scenarios the one with the higher yield? Think again! Our horizon analysis in Figure 2 shows how these two bonds should perform under different one-year interest rate scenarios: rates decline 100 basis points, rates rise 100 basis points, rates remain unchanged. 1.1 BUYING BONDS AT A PREMIUM If we look at two bonds that are identical in every way other than coupon and price, it would be rational to think that both bonds would react similarly to changes in the market. But in reality, these bonds will behave very differently. The lower coupon bond, which trades at a lower price, actually exposes the investor to more interest rate risk; in some cases significantly more. As you can see, Bond B slightly outperforms if rates decline or remain stable. But if rates rise, the outperformance of Bond A is significant. What is the reason for Bond A s considerable outperformance should interest rates rise? It s the bond s shorter effective duration in a rising rate environment. FIGURE 1: BOND COMPARISON Maturity years Call protection Coupon Yield Price Bond A 31 years 10 years 5% 3.57% $111.94 Bond B 31 years 10 years 4% 3.89% $100.90 FIGURE 2: ONE YEAR HORIZON ANALYSIS Interest rate 100bps +100bps Unchanged Bond A (5% coupon, 3.57% yield) 11.20% 3.33% 3.62% Bond B (4% coupon, 3.89% yield) 11.77% 10.70% 3.93% Difference 0.57% 7.37% 0.31% Bond A underperformance Bond A outperformance Bond A underperformance Source: DWS Investments. The Muni Opinion October 2012» 2
Without getting too deep into bond math, let s make a simplifying assumption to help better explain this example; if a bond is trading at a premium it will be called at the call date, but if it is trading at a discount to par, it will be outstanding until the actual maturity date. This is how bonds typically trade, because the assumption is that issuers will call bonds that offer above market coupon rates (and therefore trade at a premium). So when the bonds in our example are issued, both have durations of about eight years, because they are both trading at a premium and therefore the 10 year call is brought into play. But if rates rise, the duration of Bond B will become dramatically different. In our example where rates rise 100 basis points, Bond A s duration remains at around 8 years since it will continue to trade at a premium. 4 But after only a slight increase in rates Bond B s price falls below par, and its duration extends dramatically, to over 17 years. This increased duration causes the bond s price to start falling much more rapidly. The chart below shows the path both bond prices would likely take as rates move. It takes only about a 10 basis point increase in interest rates for the yield advantage of Bond B to be wiped out by price depreciation. And as rates rise, Bond B declines in value much faster than Bond A. In the opposite scenario, if rates decline, the difference in performance is limited. The bottom line is that paying a premium in the muni market is a defensive approach. Does it mean you outperform in every scenario? Nope. If rates decline or remain stable, the lower priced bond performs slightly better. But for investors looking for a more defensive stance, premium bonds are the best option. 1.2 AVOIDING TAX BILLS There is another advantage for bonds priced at a premium: they have more of a cushion as interest rates rise before the Market Discount Tax comes into play. Because it s been a while since the muni market experienced a rising rate trend, let us remind you about the impact of a market discount tax. If you buy a bond at a market discount (as opposed to an original issue discount), at a price that is below a de minimus amount (0.25% per year until maturity), and the bond matures at par or you sell the bond at a gain, then your gain will be taxed at the income tax rate. Let s look at this a different way. If you buy a bond at 100, for example, and the price declines to a market discount, what happens if you then go to sell your bond? Any buyer of your bond would take this market discount tax into account and likely pay you less to compensate them for their future tax. Thus the price of a market discount bond typically suffers due to the tax implication. FIGURE 3: BOND PRICE PATHS 15% 10% Return 5% 0% 5% 10% 15% 100 80 60 40 20 0 20 40 60 80 100 Yield change Bond A Bond B Source: DWS Investments. The Muni Opinion October 2012» 3
1.3 INEFFICIENT PRICING What may seem like a small difference a 4% coupon rather than a 5% coupon can have a significant difference in risk and performance of a bond and a bond portfolio. Furthermore, historically in the municipal bond market, pricing of bonds with different coupons has not been efficient. Often times, high coupon premium bonds offer more attractive pricing, because some investors don t understand the value of premium structure bonds. Tax accounting for mutual funds requires that the bond premium is amortized. In other words the full coupon of a bond bought at a premium is not paid out. The income distributed is essentially equal to the yield to maturity or yield to call of the bond at purchase. So in our example, we would receive income of 5%, but we would pay out approximately 3.57% as part of the fund s distribution. When the bond matures at par, its price has amortized over time there is no capital loss. So why does the muni market not price premium and par bonds correctly? There are two reasons and both relate to the retail nature of the muni market. Retail investors dominate this market and retail investors often times aren t familiar with either the two different types of bond calls or maturity extension risk. The typical muni bond with a maturity of longer than 10 years is issued with a call in 10 years. These bonds are callable bonds, but not callable before the call date. They are best described as non callable for 10 years or non call 10. Retail investors often assume that a callable bond can be called at any time. There are bonds that have an anytime call, but they are easily distinguished. This is an important distinction because if you pay a premium for a new issue muni bond, the non call 10 in our example, you are not at risk that the bond will be called immediately, causing you to lose the premium paid. As a result of this confusion, investors often shy away from all premiums bonds. 1.4 WHAT ABOUT LOSS OF PRINCIPAL? The second problem for retail investors is the perception of loss of principal. If you buy a bond at $110, and it matures (or is called) in 10 years at a price of $100, do you have a 10 point loss? This looks like a trick question, but the answer is no. Paying a premium does not mean that you will lose principal over time, as long as the income is reinvested. Because of these misconceptions, the pricing of bonds with different coupon structures does not reflect the risk and value of an efficient market. The difference in yield between Bond A and B in our example above should reflect the possibility of rising interest rates. If Bond B offered 100 bps of additional yield, then our decision would be different because the yield would compensate for the additional risk. But as long as muni investors continue to focus more on yield than value, we expect these long premium bonds to be attractive. We have often referred to this mispricing as the free lunch in the muni market. 1.5 MUTUAL FUNDS PRICED AT A PREMIUM OR DISCOUNT In today s municipal market, most long term bonds have a 5% coupon; this has been a market convention for a few years now. With 30 year AA yields at a record low, around 3.10%, most bonds with 5% coupons are priced above par. That s why the average price of many municipal bond funds is above 100. The only bonds priced below par in today s market are bonds with below market coupon rates, zero coupon bonds, or bonds with credit problems. If you are considering buying a muni fund priced at a discount, make sure there aren t too many bonds priced below par due to defaults in the portfolio. But even if there are not credit problems, you must be aware of the potential increase in interest rate risk that can come with lower priced bonds. The Muni Opinion October 2012» 4
Instead of looking at the average bond price, we would advise investing with management teams that have shown an ability to find value in the market. To us, finding value involves positioning on the most attractive portion of the yield curve and taking credit risk only when adequately compensated. Going forward, we think portfolio construction will be increasingly important. We re advocating a portfolio construction that utilizes premium bonds as a way to protect against rising interest rates. call structure strategies, or a lack of a coupon strategy, can lead to very different performance among managers during environments of high interest rate volatility. The opinions and forecasts expressed herein by the fund managers and product specialist do not necessarily reflect those of DWS Investments, are as of 10/29/12 and may not come to pass. Securities referenced should not be construed as a recommendation of any specific security. So does that mean we are calling for a rise in rates? No, we don t have a crystal ball, and we don t claim to know where rates will be in 12 months. But we re more than happy to give up a moderate amount of performance to the upside in order to significantly protect the portfolio in the event of rising rates. The opportunity for slightly higher upside returns simply does not justify the potential downside volatility that investors may experience if they own low coupon discount priced bonds. This article is not intended to provide tax or legal advice and should not be relied upon as such. Any specific tax or legal questions concerning the matters described in this article should be discussed with your tax or legal advisor. DWS Investments, including its subsidiaries and affiliates, does not give tax or legal advice. Investors must know the risk exposures their portfolio has the types of risk as well as the degree of risk. Exposure to long maturity discount bonds is one factor that took some muni fund returns down significantly in 2008. Different coupon/ 1 Credit quality measures a bond issuer s ability to repay interest and principal in a timely manner. Rating agencies assign letter designations such as AAA, AA and so forth. The lower the rating, the higher the probability of default. Credit quality does not remove market risk and is subject to change. 2 The yield curve is a graphical representation of how yields on bonds of different maturities compare. Normally, yield curves slant up, as bonds with longer maturities typically offer higher yields than short-term bonds. Spread refers to the excess yield various bond sectors offer over Treasuries with similar maturities. When spreads widen, yield differences are increasing between bonds in the two sectors being compared. When spreads narrow, the opposite is true. 3 One basis point equals 1/100 of a percentage point. 4 Duration, which is expressed in years, measures the sensitivity of the price of a bond or bond fund to a change in interest rates. The Muni Opinion October 2012» 5
IMPORTANT RISK INFORMATION Bond investments are subject to interest-rate and credit risks. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Investments in lower-quality and nonrated securities present greater risk of loss than investments in higher-quality securities. The fund invests in inverse floaters, which are derivatives that involve leverage and could magnify the fund s gains or losses. Although the fund seeks income that is federally tax-free, a portion of the fund s distributions may be subject to federal, state and local taxes, including the alternative minimum tax. See the prospectus for details. OBTAIN A PROSPECTUS To obtain a summary prospectus, if available, or prospectus, download one from www.dws-investments.com, talk to your financial representative or call (800) 621-1048. We advise you to carefully consider the product s objectives, risks, charges and expenses before investing. The summary prospectus and prospectus contain this and other important information about the investment product. Please read the prospectus carefully before you invest. Investment products offered through DWS Investments Distributors, Inc. Advisory services offered through Deutsche Investment Management Americas, Inc. DWS Investments is part of Deutsche Bank s Asset Management division and, within the U.S., represents the retail asset management activities of Deutsche Bank AG, Deutsche Bank Trust Company Americas, Deutsche Investment Management Americas Inc. and DWS Trust Company. DWS Investments Distributors, Inc. 222 South Riverside Plaza Chicago, IL 60606-5808 www.dws-investments.com inquiry.info@dws.com Tel (800) 621-1148 2012 DWS Investments Distributors, Inc. All rights reserved. PM124038 (10/12) R-29715-1 MUNI-OPIN-OCT