Volatility Will Hang On Into 2008 But Ease Eventually, Manager Says

The volatility of recent months will continue into 2008 but the municipal market will eventually find solid footing, said Steven Permut, senior vice president and portfolio manager at American Century Investments. Speaking at a roundtable discussion in New York yesterday, Permut said that what happened this summer and fall is a sign of a changing tax-exempt market, and one that has changed for good.“August was scary and fascinating at the same time depending on how you look at it,” Permut said. “It serves as an example of how our market has changed. We will eventually find stability but turbulence will continue through the end of 2007 and into next year.”He added: “While we will scale back volatility eventually, we now live in a new market because we have a crop of new buyers out there that change how business gets done.”Permut attributed market volatility in August to three forces, including the new nontraditional investor.“The unwinding of leverage put on by hedge funds, arbitrage funds, and tender-option bond programs; the credit default obligation exposure of insurers; and limited liquidity by the broker-dealer community are the principle reasons for the volatility,” he said.As a result, his funds have changed some of their investment strategies. He is also maintaining higher cash levels in his funds in order to be able to meet increased redemptions, should they occur.Permut said a strategy of steepening trades has paid off from American Century’s muni funds over this period.“We expect the economy to slow down and have adjusted our funds accordingly,” he said. “When this happens, you tend to see the yield curve steepen out and we look to take advantage of that.”One such steepening trade is done in the Treasury market, he noted. In this trade, the fund will buy on the short end, likely in two-year Treasury bonds, and then short on the longer end, likely in 10-year bonds. Thus, if the 10-year bond yields increase, the value of holding a short will increase. Buying on the short end will be advantageous as the bonds will appreciate as the curve steepens, assuming that short-term yields decrease.To offset the capital gains tax incurred by this transaction, the fund would enter into tax swaps.Permut said he did not expect municipal credit spreads to widen out as much as they have. He said that in his taxable debt funds, he had sold many weaker credits and bought high quality, but did not do this as much with his municipal funds. According to Municipal Market Data, the spread between triple-B and triple-A general obligation bond yields maturing in 30 years was 35 basis points on July 5. On Nov. 26, the spread was 72 basis points.Permut was quick to point to the relative cheapness of munis compared to Treasuries in today’s market, calling munis a very overlooked product. On Monday, MMD’s 30-year yields were 102.3% of 30-year Treasuries. Over the last year the ratio has averaged 87.9%. While this relative cheapness of munis to Treasuries is similar to the relationship between the assets in late August of this year, Permut said not to expect a rally similar to what occurred in September, when the market firmed on a strong retail bid.“We won’t see the rally in November because this time the problems in the market are linked to the perceived problems of the monoline insurers, and that is a big issue for retail,” he said. “This problem we have right now will take a longer time to work through the system.”American Century Investments maintains six municipal bond funds, and according to Morningstar Inc., the fund family has roughly $2.8 billion in municipal assets under management. That represents just under 3.5% of the company’s total assets.