Mark V. McCray, Managing Director

John Cummings, Executive Vice President

Municipal bond prices moved sharply lower over the summer as concerns about subprime mortgage loans came to a head and spurred a broad credit crunch. The growing high-yield municipal bond market was hit particularly hard by the sell-off. In the interview below, PIMCO’s municipal bond experts, Managing Director Mark McCray and Executive Vice President John Cummings, discuss PIMCOs views on the municipal bond market and high-yield munis and explain why the recent sell-off may create investment opportunities.

Q: The municipal bond market has sold off dramatically relative to Treasuries and other taxable sectors of the bond market. Is the sell-off in munis a result of underlying credit problems in the sector, or were other forces at play?
McCray: The decline in the muni market that began in August was not precipitated by a credit event in the municipal market, but by a liquidity event in the municipal market set off by credit and liquidity conditions in other markets. The decline in muni market liquidity began in early August and accelerated as the month progressed.

Several things were happening. Volatility in other sectors and markets led Wall Street firms to reduce risk and reduce balance sheet exposure in general, which eventually forced the municipal desks to reduce risks. So the proprietary trading desks needed to reduce their muni positions in a market with no liquidity. On top of that, as arbitrageurs and muni desks aggressively sold, a very unusual situation arose in which prices on muni bonds were declining at the same time prices of Treasury bonds and the LIBOR swaps that these trading desks typically use to hedge their muni exposure, were rising. In other words the hedges that trading desks utilize were not performing as expected which exacerbated the situation.

Q: This was a very sudden move downward for the municipal bond market. Can you give us some perspective on current price levels?
McCray: Historically when tax-free municipal bonds yields are as high or higher than taxable Treasury yields, they have been a very good relative value. However, this has been a unique price decrease for munis because in addition to underperforming Treasuries they under-performed swaps. Even as the spreads between LIBOR and Treasuries widened, the spreads between municipal bonds and LIBOR widened a lot.

To put this current relative value into historical perspective, back in 2003, munis got similarly cheap versus Treasuries, although not nearly this quickly. At that time, looking at ratios between 30-year municipal and Treasury bonds, for instance, muni yields got as high as 104%-105% of Treasury yields, and they eventually came back down to 88%.

Q: As a long-term investor, how do you react to this kind of short-term volatility?
McCray: At PIMCO we have a philosophy built on years of experience managing municipal bond portfolios. Imagine that munis are attached to the Treasury market by a rubber band. Sometimes, the taxable market will walk along nice and slowly in one direction and munis will follow along virtually in lock-step. Other times, the taxable market will sprint in a certain direction and munis will just stand in place and the rubber band stretches.

Our goal is to position portfolios so that we are not forced out of positions when the rubber band stretches really wide, because eventually the rubber band pulls the relationship back together. And the reason the rubber band pulls the markets back together is that, at the end of the day, municipals are still tax exempt. Thus, barring a major shift in municipal credit nationwide, munis should still command a price premium, or lower yields, relative to taxable bonds.

But, when you run the portfolio you have to respect the fact that the premium for munis versus Treasuries can become very small, or even negative, for periods of time, and you need to be able to hold your muni positions and ideally add to them during that type of distress. What we’ve done now is add to our exposure, upping our muni duration in portfolios relative to Treasury duration where possible. In other funds it also means selectively adding more exposure to muni credit risk on this spread widening.

Q: John, high yield munis were hit harder than high-grade munis, is there opportunity in the current higher yields and lower price levels?
Cummings: We think current price levels present a buying opportunity. Most of the municipal bonds PIMCO buys are secured by a first mortgage lien on an asset. When you can buy some of these credits in the high 80% to low 90% of par, you take less credit risk, and you have positive convexity; meaning the price is more sensitive to falling yields. We think this is one of the better opportunities we’ve seen in the high yield market.

PIMCO believes this is a good time to raise high yield exposure. If the spread between munis and Treasuries were to narrow by 40 basis points, then you might upgrade the credit quality of the bonds in your portfolio.

Q: Were there separate factors that helped push high yield prices farther down?
Cummings: The high yield municipal market sold off with the general municipal bond market, but we believe high yield muni bonds sold off more for a couple of reasons. One of the big drivers of the widening in spreads between high grade muni bonds and high yield muni bond yields was the fear a collateralized debt obligation (CDO) of high yield munis under construction would be unwound, forcing hundreds of millions of dollars worth of high yield muni bonds into the market. A number of dealers and funds in the marketplace panicked and tried to get out in front of that, to sell bonds before the CDO did, which had a ripple effect in the high yield muni market. Net asset values went down in high yield muni funds, causing redemptions, and those funds had to sell munis to meet the redemptions. Because the selling happened in what was essentially a liquidity vacuum, prices suffered quite a bit.  Dealers were trying to clear their shelves and get rid of high yield muni paper, high yield muni mutual funds were selling to meet redemptions, and arbitrage accounts were selling bonds to reduce the leverage of their highly-levered  muni positions. The high yield muni market had not seen this type of a liquidity event since about 1987 or ‘88.

Amid all this, a $500 million Michigan tobacco deal came into the market. Long-term New Jersey and California tobacco settlement bonds were trading at yields of 5.90% and 5.85%, respectively, but in order to make sure the entire deal was sold and the syndicate was not left with any bonds, the Michigan deal was priced at 6.25%. This deal literally helped to re-price the entire high yield muni market by 25-30 basis points.

Q: How is PIMCO positioning its high yield municipal bond portfolios to take advantage of these recent events in the market?
Cummings: We have been buying additional high yield municipal bonds. The CDO that had scared the market was not, in fact, a forced liquidation, and we have been buying their paper as it is slowly unwound. And the forced sellers appear to be gone – as if they sold out everything they had. Plus, you had a lot of high yield muni funds sell more than they needed to sell in order to meet anticipated redemptions, and they built up more cash than was necessary to meet redemptions. Then as the high-grade municipal bond market rallied the high yield muni market rallied along with it, and redemptions ended.

I think many managers will run higher cash balances going forward in anticipation of redemptions. So there may be a swing toward more cash on hand which should cushion the shock if there is another sell-off in the future.

Since we are quite comfortable with the credit quality of the high yield bonds we own, because of our extensive credit research process, we see this as an opportunity to add to our positions in the bonds we already know and own, putting PIMCO in a position to potentially outperform as credit spreads tighten.

Q: Mark, you’ve described this primarily as a liquidity event. Are you seeing signs of improved liquidity or of supportive factors entering the market?
McCray: There is a lot more liquidity in the market and a lot of interest to buy municipal bonds. It’s the start of a new quarter for some of the broker-dealers, and their balance sheet constraints may ease. As the dealers get back in the business of buying and selling muni bonds, having positions and making markets, I expect liquidity will get even better. We are also seeing and hearing of inquiries to buy from foreign banks that occasionally dabble in municipals as a crossover play. These buyers are coming in, looking to put on large trades, but have not been able to find a lot of bonds for sale. The bids are reflected in the municipal derivatives market as these institutions look for other ways to get large exposures to current spreads between municipal bonds and taxable sectors. I think all of these things will be supportive.

A word of caution, however: if some other shoes drop, some more skeletons come out of the closet -- and they don’t necessarily have to be municipal bond skeletons -- that will probably have an impact on munis. If something comes up in the asset backed market, or if a commercial paper program is not able to roll, and all of a sudden you see T-bills running down toward 2% or 1%, and you see credit spreads widening, to the extent that forces broker dealers to reduce risk even further than they already have, there could be more fallout for munis.

Although I will say this – the dealers really have cleared the decks of their muni positions. There are firms who tell us: ‘look, we just don’t own anything. We can’t offer you anything because we don’t own anything.’ So I’m not even certain that another risk reduction down the line would really hit the municipal market as hard. The final caveat is that if the Treasury market rallies very rapidly in large scale, we generally tend to lag during those periods.

Q: Are the current levels in the muni market attractive on a relative value basis for investors in the taxable space as well?
McCray: PIMCO believes this represents an opportunity for fixed income investors with other benchmarks as well.

PIMCO is setting up total return portfolios in an effort to achieve three things. The first component is to buy high grade, good quality, well structured municipal bonds yielding 100% or more of comparable Treasury yields. Interestingly, we found liquidity to be almost as challenging on the buy side as the distressed sellers found on the sell side.

The second component is to add credit on weakness, and we were able to add municipal bonds at distressed prices, but not distressed credit quality, which, of course, was unchanged from where it was six weeks before the liquidity crisis.

The third component is to add more liquidity to the market, if necessary, by being active in the market. So to sum up – a three pronged strategy: buy good quality and well structured municipal bonds at distressed prices, and be ready to step in and add liquidity should things get worse.

Q: Thank you Mark and John.