Relief Pitcher

DM: We have a deep research staff that is divided by sectors–if you’re familiar with the municipal marketplace, there are the tax-backed general obligation issuers and a number of different revenue bond sectors. We have a research staff, including nine analysts, that are divided among the various sectors that issue municipal bonds. They look at the credit of each issuer–even bonds that come with AAA-rated bond insurance attached to them. Our analysts look at every deal–at the underlying credit–to give us their opinion as to the credit quality of the underlying bond, so that we are not simply relying on any credit enhancement coming from the bond insurer. They look at things beyond the credit as well. They’re looking at structural features such as what types of extraordinary redemption calls might exist within the indenture, and whether there is any chance that the bonds could ever be deemed taxable by the IRS because of risk that the issuer wasn’t meeting the requirements to maintain their tax-exempt nature. It’s a very veteran staff. We’ve had very little turnover as far as people leaving Fidelity. Having that research staff has been a big part of why we’ve performed so well over the last few years. We also have four dedicated traders [that] really add a lot of value. There’s not a lot of transparency in where municipal bonds are trading at all times. Our traders are out there talking to The Street, developing opinions as to how various types of bonds are trading and what may be cheap or rich in their minds.

MS: One of the key things that distinguishes us from other managers is that we don’t make interest rate calls; [we are] not swinging the duration of these funds at all. That allows other strategies to emerge, to outperform. We have a dedicated quantitative analyst who is helping us develop metrics that we can use to understand the potential for refundings in securities, and tie that in to research we are doing at the issuer level to understand issuer motivations, and their incentives or economics, to give ourselves a better shot at finding refunding opportunities.

We’re focused on the tax laws–in the muni market there’s a very important tax law for discount bonds. We haven’t seen this law be very important in recent years, but five years ago the market was obsessed with [it] because everything was trading at a discount, and understanding how that law affected different types of structures in our market, and using our quantitative tools to do that, was very important in our outperformance in that type of environment. It’s something that we pay attention to in every bond that we buy even now, in a current low-interest-rate environment where virtually every security is trading at a premium, because the rest of the market is not so focused on it.

We have yield curve strategies, again using proprietary analysis, and we have a whole team of quantitative analysts that are focused on interest-rate modeling and tools. Individuals who might primarily be focused in taxable markets are building tools that we can utilize in the muni market. From talking to people at conferences that we attend, we get some sense that we’re well ahead of many shops in terms of our interest-rate modeling and other quantitative analytics and models that we’ve built to operate in the muni market.

Is that because of your quantitative and proprietary models or is it the layers of research? MS: It’s a combination of being able to leverage expertise that we have in our taxable markets, and resources that we have in technology. We have a technology group of roughly 70 people, programmers who are working with our quantitative analysts to help build these models, and an investment in people and technology.

CT: We have models that allow us to understand from a valuation perspective how bonds with different characteristics compare, and we collect this data so we can see how bonds with different structural characteristics have compared over time in different kinds of market environments. Some of the quantitative tools have the ability to model the embedded optionality (price or yield change for bonds with embedded options), the embedded tax exposure, securities under the market-discount tax law, things that help us on a security-by-security basis choose which bonds have the best contribution to move the overall portfolios. Every night we have a cycle that we run all of our securities through. We’ve created 12 separate scenarios; every night we model what the expected performance would be of each individual security in each of our funds, as well as in its identified benchmark. We use Lehman Brothers Indices as each fund’s benchmark, so that we can see what happens to relative performance of a portfolio if, for instance, interest rates increase a little, if they increase a lot, if they fall by a little, if they fall by a lot, if the yield curve steepens, or if the yield curve flattens.

Would you please walk me through the market discount tax law? MS: Each bond has a discount price. If it falls below that price, the buyer of that security may be subject to ordinary income tax on subsequent capital appreciation, so if they bought it at 90 and the [discount] threshold was 91, and held it to maturity [and then redeemed it for 100], all 10 points would be subject to ordinary income tax–not just the one point back up to the threshold. If the bond’s price falls close to the threshold, say 92, it’s going to be penalized because it’s getting close. It was a huge contributor to our performance in 1999-2000 in an environment when rates were higher, and where bonds were potentially impacted by this law.

CT: In 1999, roughly a third of the broad market fell below these de minimis thresholds, and the market went from people really not paying a lot of attention, to truly obsessing on this characteristic because of the tax ramifications of buying a security at a discount price below the threshold.

How do you keep your expense ratio so low? CT: The three of us don’t set the expenses of the fund but we do manage so that economies of scale will benefit our investment process.

Where does this fund fit in an investor’s portfolio? CT: Fixed income has a continuous role in a diversified portfolio and municipals add value in any fixed-income allocation–outside of retirement accounts. Municipals have a lower volatility through most market cycles. There are historical return advantages, supported by superior default histories, over taxable alternatives. With a track record of competitive returns over time the fund is a good vehicle representing the municipal market at large. If you need your money within a one-year timeframe you probably should have it in a money-market type of investment. As your time horizon stretches out to two or three or more years, funds like the Fidelity Tax Free Bond Fund can be a part of your fixed-income component in your portfolio.

What else should advisors know about the fund? MS: Our philosophy is that we’re investing for total return, and yield is an important component of total return but we’re not simply trying to maximize yield. We’re looking at opportunities for price appreciation. Chris was talking before about AMT. If you avoid all AMT[-subject] bonds you may be giving up opportunities to buy bonds that look poised to rise in price, dramatically, even away from the fact that they are exposed to the AMT. To the extent that they fix the AMT problem, probably all AMT bonds will enjoy some spread tightening and price appreciation, but even away from that, you can imagine particular AMT bonds doing well despite their AMT disadvantage.

CT: Yield generally indicates higher risk, and it can be a good risk that can make you money, or it could be a risk that is going to cost you in terms of the return of your principal. One of the things that frustrated me on the heels of September 11th was that some people were taking note that our yields were slipping relative to others in the industry and part of what was going on behind those numbers was the fact that we had no exposure to airline bonds–not airport, but airline bonds–in our portfolios. In the prior period airline debt had fallen from 90-cents-to-par price ranges to 20-40 cents on the dollar. Because those securities hadn’t actually defaulted they were doing wonders for the yield of some other portfolios. Somebody can have a view on whether or not those securities were a buy, but to choose investments based on yield without an eye towards what historical total return performance has been would have been a huge mistake. We encourage people to look at the return histories of funds, to look at the return volatility over time. We believe that investors don’t want equity-like volatility in a municipal bond fund. Instead most investors want more consistent, competitive performance year after year, and that’s what we seek to deliver.

Staff Editor Kate McBride can be reached at [email protected].