Thornburg Manager Josh Gonze Doesn’t Buy the Muni Hype: The Weekend Interview

‘Low prices, high yields, good time to buy,’ says Gonze

In a Dec. 19, 2010 “60 Minutes” segment, banking analyst Meredith Whitney predicted a tidal wave of defaults in the municipal bond market in the near future, perhaps totaling billions of dollars. Her reasoning was 50 to 100 cities may default on interest payments over the next 18 months.

Josh Gonze (left) doesn’t buy it. The co-portfolio manager and managing director of Thornburg Investment Management  believes the time is right for muni bond investment, and explains why the space should continue to receive careful consideration from advisors

Q:  You believe that now is an opportune time for municipal investment. With everything facing state and local municipalities, why would that be the case?

A:  Negative media coverage regarding budget deficits and other fiscal problems has triggered a sell-off. This sell-off caused bond prices to fall and yields to rise by about 100 basis points in the last three months, which is a sharp rise in yields. For a long time prior to this sell-off, municipal bonds were very expensive and yields were somewhat unattractive. Now, suddenly, they look much better. For example, we can buy 10-year AA rated bonds at yields in excess of 4%. For a long time, that wasn’t possible.

Q:  Obvious question, but is that smart if the risk of default is elevated?

A:  I don’t think that’s the case for numerous reasons. We recognize that states and municipalities are under fiscal stress and facing large budget deficits and unfunded pension liabilities. But the debt problem is not out of control. The median cost of servicing debt as a percentage of expenditures is about 3%.  So if states were to default on their debt service it would not save them much money. There’s very little to be gained by defaulting and a great deal to be lost.

Q:  What about the ratio of debt to personal income; is that a solid indicator?

A:  Right, Moody’s measures that and the number has ranged between 2.5% and 3.5% every year since 1995. If we use that ratio, which is completely different from debt service as a percentage of state expenditures, it indicates that the cost of servicing the amount of debt that’s out there is reasonable. That said, those are macro numbers across all 50 states. There are individual pockets where we think that fiscal problems are serious and substantial. You shouldn’t just buy any bond. For example, we at Thornburg are skipping over things such as Detroit GOs; virtually all bonds from Puerto Rico. . .

Q:  We’ve heard that territory paper is pretty good, like Virgin Islands, but you’re saying it’s not?

A:  We will buy Virgin Islands, but not Puerto Rico or Guam. There’s a lot of Puerto Rico paper, in particular, that’s commonly found in mutual funds. Our call is that the credit ratios are very weak and that it’s best to be avoided. Many people will disagree with me and that’s what makes our market interesting.

Q:  Standard and Poors came out with a report saying more downgrades are likely in 2011? Do you agree with their assessment?

A:  Yes, I do. I don’t think we’ll experience a tidal wave of defaults. We will continue to see a limited number of defaults, as we always have, and downgrades. And Moody’s said the same thing. What they’re telling us is that the number of actual defaults for investment grade bonds remains negligible, and if that number were to double or triple or quadruple it would remain negligible. The press often says “a number is doubling,” but if the number is almost infinitesimally small to begin with, a doubling doesn’t really mean much.

Q:  So you’re blaming us in the press for creating a self-fulfilling prophesy.

A:  Ever since the Meredith Whitney interview, she’s gotten so much blow back in the press.  So many people have said, “Hey, you’re overdoing it.” It’s tempting to predict the sky is falling because it attracts attention or you can make yourself a hero if by some remote possibility it all comes true. But what do I think, as a professional bond investor who actually looks at the numbers for myself rather than just listening to somebody on television? I just don’t think the fiscal stress out there is going to trigger bond defaults for major bond issuers.

Q:  So low prices, high yields. Perfect time to buy?

A:  That’s correct. Low prices, high yields, good time to buy.

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