In the category of timely topics, you can’t get much that’s fresher than this: in our spotlight this month we’ve got municipal bonds, the alternative minimum tax, tax reform, tax-free income, and three exceptional portfolio managers–all in one feature. Municipal bonds are of the moment because of subjects your clients are likely to be discussing right now: rebuilding communities in the wake of Hurricane Katrina, and taxes or tax reform–a timeless topic, but timely as well. A Congressional Ways and Means subcommittee hearing on tax reform that was originally scheduled for September 20th was postponed indefinitely while Congress works on Hurricane Katerina issues. One of the items on the agenda was the alternative minimum tax (AMT). An interview with those three managers is timely in another way: it introduces a special section on year-end tax planning just as we enter the fourth quarter.
Taxes and “munis” are linked in a number of interesting ways. State and local taxes pay the interest on bonds that are general obligations (GO bonds) of states and local municipalities. Revenue bonds–issued to finance projects that benefit the public, such as housing and hospitals; ports and airports; pollution control systems and stadiums–are secured by the revenues that those projects generate. Chances are that municipal bonds will be issued–some with private insurance backing them; some may have federal backing–to help rebuild parts of Louisiana, Mississippi, and Alabama.
Municipalities that issue muni bonds have the power to raise taxes in order to pay off the bonds, and because of that, investment- grade GO munis are considered extremely safe investments, second only to Treasury bonds in their ability to make good on their promise to pay. That doesn’t mean that their value doesn’t fluctuate day to day–of course it does in lockstep with interest rates–but clients can expect to receive timely payments of interest and principal if the bonds are held to maturity. Because of their safety and because the interest earned by investors is tax exempt, localities that issue munis save taxpayers billions of dollars in state and local taxes, because the rates munis pay are lower than interest rates paid on taxable bonds. When advisors’ clients buy munis issued in the state where they live, the interest clients earn is free from federal, state, and local taxes. But wait, is it really tax free? What if your client is one of the millions of Americans who are, or are about to be, subject to the AMT? Income from some munis is subject to the AMT, so it is important to know whether the munis your clients buy really are exempt from AMT, or are subject to the tax.
A Brief History of the AMT
The AMT was enacted in 1969 after it was discovered that because of loopholes in then-existing tax laws, 155 wealthy persons paid no federal income tax in 1967, even though their adjusted gross income (AGI) was above $200,000 (about $1.1 million in 2001 dollars), according to a 2001 Congressional Joint Economic Committee Study entitled The Alternative Minimum Tax for Individuals: A Growing Burden. By 1975, 20,000 individuals paid taxes under the AMT, and National Taxpayer Advocate Nina Olson estimated last year in testimony to Congress that by 2010, 30 million American taxpayers will be subject to the AMT (for further insight into the alternative minimum tax and how to address it, see Part III of our special year-end tax planning report on page 72 of the October issue).
So how do you know which munis are subject to the AMT? That’s where Christine Thompson, portfolio manager for the $345 million no-load Fidelity Tax-Free Bond Fund (FTABX), can help. The fund invests primarily in munis that are not subject to the AMT. “The Tax-Free Bond Fund is the newest fund [April 2001] we’ve added to Fidelity’s municipal bond group of products, because there was the observation that the alternative minimum tax (AMT) was expanding to include more people and the inclusion of bonds that may not be excluded from the AMT could grow to be a problem,” says Thompson.
According to Standard & Poor’s, the fund had three-year annualized returns of 5.75% versus 3.31% for the Lehman Brothers 5 Year Municipal Bond Index. The fund was renamed in August; it had been called the Spartan Tax-Free Bond Fund.
Standard & Poor’s ranks the fund four stars overall, while Morningstar gives five stars. Morningstar said recently it “could be the Holy Grail of bond funds,” and named Fidelity’s municipal bond fund team “Fixed-Income Manager of the Year for 2003.”
That team is led by Thompson and colleagues Doug McGinley, portfolio manager of the Fidelity Intermediate Municipal Income Fund, and Mark Sommer, portfolio manager of the Fidelity Short-Intermediate Municipal Income Fund, at Fidelity Research & Management in Merrimack, New Hampshire.
Do you three manage any funds together? CT: Actually, we have distinct responsibility for separate funds. Our municipal fund line-up includes five national funds: Mark manages the Fidelity Short-Intermediate Municipal Income Fund; Doug manages the Fidelity Intermediate Municipal Income Fund; and I manage the Fidelity Municipal Income Fund, Fidelity Tax-Free Bond Fund, and a fund for advisors, Fidelity Advisor Municipal Income Fund. In addition, we have 12 state funds and we all share responsibility for different funds there.
MS: We specifically have taken our Fidelity municipal product line and divided it up so that we all have involvement in a national market, and a different emphasis across the yield curve, as well as all have responsibility for single-state funds.
We have divided the market up in such a way that there is a certain amount of specialized focus, and with that focus we can help each other. We have overlap in the states that we cover; we have overlap in various parts of the yield curve.
What about the AMT aspect of the Tax-Free Bond Fund? CT: We can talk about AMT–where is it going, what are they going to do with tax reform–that’s all pending and a lot of that’s uncertain. Clearly there will be a large portion of the population that will become subject to the AMT if reform measures aren’t taken, and this was a fund that was introduced in order to provide an investment option for people who didn’t want to include AMT securities. What I emphasize when I talk about AMT even in our other 16 funds, is that it’s not a dominant strategy, because we invest with a goal of providing strong total returns, and not yield for its own sake. We only invest in things subject to the AMT to the extent we think they are going to offer a return advantage to other securities. If you look at the percentage of AMT bonds in our other funds it ranges, I’d say, over the past five years, somewhere between maybe 5% and 15%, so it’s not a large portion of the income of any of those portfolios. I’d encourage investors not to disregard funds that have a small [AMT-subject] component because [there may be] valuation-driven opportunities in that sector of the market that are compelling enough that you would accept a small portion.
Can you tell us about your investment process? CT: Fidelity’s approach is to invest in resources that help us employ valuation-based strategies to generate competitive, consistent returns for our shareholders. To do that we emphasize a number of research strategies that are tied to fundamental research, and work done by our credit research department, as well as strategies and tools that are quantitatively based and enable us to model individual securities, compare the characteristics of those securities, and understand on an aggregated basis how our funds are expected to perform relative to the market in general. We have a team of over 20 people that contribute to the performance of our funds. There are three fund managers [and] we three are the ultimate fiduciaries responsible for the performance of the fund.
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@example.com.