Reprinted with the Permission of BlackRock
Although slow to start, new municipal issue supply ramped up quickly over the quarter. Compared to the same months in 2011, supply increased by 37% in January 2012, 60% in February and over 80% in March. According to Thomson Reuters, overall issuance for the first quarter of 2012 was 63% higher than the same quarter last year, an increase of $30.1 billion. These first-quarter supply figures suggest that total new issuance in 2012 is likely to exceed that of 2011, but remain below the running average for the most recent decade. It is important to note that, unlike other periods, much of the first-quarter issuance was attributable to debt refunding and, therefore, did not add to the overall net supply of tax-exempt paper, nor did it put pressure on rates.
During the first quarter, more than 50% of new issue supply was due to debt refunding as issuers capitalized on the low interest rate environment to call in their old debt and reissue it with new lower-cost financing. As interest rates are expected to remain low for an extended period of time, additional refunding of older debt may continue to increase the rate of new issuance through the remainder of 2012. While consensus expectations for new municipal issuance in 2012 range from $325 billion to $350 billion, several investment banks project that a high level of refunding activity will result in a net negative supply figure for the year. At this point, market supply seems manageable, especially considering the ongoing austerity measures at the state and local levels.
On the demand side, according to Lipper/AMG, cash flows into municipal mutual funds totaled a net positive $8.3 billion during the first quarter of 2012. The same quarter in 2011 saw a net outflow of $16.1 billion as a flood of inflated headlines about municipal finance troubles drove investors away from the market.
Preliminary data from all 50 states indicate that collections from major tax sources in the fourth quarter of 2011 were 2.7% higher as compared to the same quarter of 2010, according to the Nelson A. Rockefeller Institute of Government. While this marks an eighth consecutive quarter of increased collections after five straight quarters of decline, these results reflect a noticeable slowdown from the 11.1% and 6.1% year-over-year growth reported in the second and third quarters of 2011, respectively. On an individual basis, 41 states reported gains in overall tax collections during the fourth quarter of 2011, while 9 states reported declines.
The US Census Bureau reported that state revenue receipts in the fourth quarter of 2011 were 3.5% higher than the same quarter of the prior year. Property taxes increased a mere 0.2% during the fourth quarter of 2011, year-over-year. Property tax receipts are under strain due to declining assessment values and state-imposed property tax limitations, which tends to increase operating pressures on local governments.
High unemployment rates continued to put a strain on state revenues. According to the Bureau of Labor Statistics, state unemployment rates were little changed in March with 30 states recording month-to-month declines, 8 states posting rate increases and 12 states unchanged. Year-over-year, unemployment rates were down in 49 states in March. The states with the highest unemployment rates were Nevada, 12.0%; Rhode Island, 11.1%; and California, 11.0%; while the lowest rates were reported in North Dakota, 3.0%; Nebraska, 4.0%; and South Dakota, 4.3%.
While many states continue to struggle with budget gaps, overall, shortfalls have declined from the recessionary peak. According to the Center on Budget Policy Priorities, 30 states reported budget gaps totaling $49 billion for the upcoming fiscal year 2013, which begins July 1, 2012 for most states. This compares with the cumulative $191 billion budget shortfall recorded in the fiscal year 2010.
While credit stress has shifted from the states to the local level, the strain on local governments has led to only a few isolated, albeit well-publicized, defaults which were largely shrugged off by investors. Overall, fiscal distress at the local level remains on the periphery.
Northeast Central (Illinois, Indiana, Michigan, Ohio, Wisconsin) — 5.2% overweight (15.3% of portfolio)
The fund’s holdings in this region remain concentrated in revenue bonds, mainly for hospital and transportation projects. Exposure to state and local general obligation (“GO”) bonds remains limited, as many of the local economies are highly cyclical, characterized by job losses in the manufacturing sector, and we expect to witness a long-term economic decline in the area.
Southwest Central (Texas, Arizona, Louisiana) — 4.3% overweight (13.0% of portfolio)
The fund’s exposure to the Southwest is held primarily in revenue bonds for various purposes, including major-market airports, well-established toll roads, large system hospitals, and water and sewer projects. The fund also maintains a limited exposure to Texas GOs. Texas boasts below-average unemployment led by private-sector job growth, although the public sector has continued to cut jobs.
Pacific (California, Alaska, Oregon, Washington) — 0.1% underweight (21.9% of portfolio)
Exposure to this region continues to be concentrated in California, which represents 18.5% of the fund’s total assets. The position consists primarily of revenue bonds diversified across several sectors, including hospitals, transportation, special tax and utilities, with 2% allocated to state-issued GOs.
South Atlantic (Delaware, Maryland, DC, Florida, North Carolina, South Carolina, Georgia)— 3.8% underweight (11.5% of portfolio) Our current strategy for this region favors states with greater economic diversification, such as Florida and Georgia. These two states are particularly attractive for their population growth prospects and conservative budgeting. The fund’s allocation to the region is diversified across the seven states; however, more than half the holdings are in Florida.
Middle Atlantic (New York, Pennsylvania, New Jersey) — 9.1% underweight (13.0% of portfolio)
The fund’s holdings in these states are composed almost entirely of revenue bonds backed by various sources, including toll roads, hospitals and schools.
Healthcare (Hospitals, Retirement Communities) — 4.4% overweight (14.8% of portfolio)
We maintained the fund’s exposure to hospitals during the quarter (representing approximately 15% of the fund’s healthcare holdings at quarter end). Within the hospital segment, we continue to stress the importance of strong management and favor larger, high- quality names with dominant market shares and strong balance sheet metrics. We are finding tactical buying opportunities as spreads in this space remain wide by historic standards.
Utilities (Water and Sewer, Public Power) — 3.7% overweight (18.1% of portfolio)
The fund maintained its overweight to this defensive sector, which has historically performed well during periods of slow economic growth. The utilities sector remains attractive for its lack of direct competition and its autonomy in setting rates. Additionally, utility companies are not dependent on state aid in order to service their debt. We prefer projects with large and affluent customer bases, independent boards that set rate hikes or customer bases that have no alternative to the public utility.
Transportation (Toll Facilities, Airports, Seaports, Parking) — 3.0% overweight (14.2% of portfolio)
The fund’s transportation holdings remain largely concentrated in airports and toll facilities. Within the airport segment, the fund’s holdings reflect a preference for airports in major markets throughout the country, particularly established airports with wide carrier diversification, including both legacy and low-cost carriers. In toll roads, we prefer established roadways, particularly in the northeast where authorities have recently enacted higher toll rates. The fund remains underweight in start-up toll roads.
Corporate-Backed Munis (Chemicals, Electric, Environmental, Paper, Utilities)—2.5% overweight (5.9% of portfolio)
We continue to maintain a concentration in electric utilities as we target companies operating in favorable regulatory environments. Utilities are relatively defensive given their stable credit metrics and the recovery of power costs; however, risks include capital expenditures for environmental matters, increasing write-offs for bad debt and regulatory uncertainty. We continue to hold modest weightings in environmental, paper and chemicals companies.
Education (Private and Public Universities, Charter Schools, Student Housing, Student Loans)— 1.6% underweight (6.0% of portfolio)
The fund’s underweight to education decreased over the first quarter of 2012 as we found more opportunities in this space amid increasing supply. We prefer top-tier private universities that can maintain pricing power and have large endowments, strong student demand and high matriculation rates. We also favor certain well-positioned public universities.
Tax-Backed (Cities, Counties, Authorities, State GOs, School Districts, Development Districts, Dedicated-Tax Bonds)— 15.7% underweight (26.5% of portfolio)
The fund remains underweight in tax-backed issues, particularly in cities, counties and local authorities. Burdened by fiscal problems and tight budgets, states continue to cut aid and pass costs down to local municipalities. We maintain an underweight in school districts, which remain under pressure due to cuts in state aid. We prefer broad, dedicated-tax bonds over GO bonds. Within GOs, our bias is toward stronger states given their sovereignty, monopoly of services and inability to file for bankruptcy.
As of quarter end, the fund’s duration was approximately 0.25 years longer than the benchmark, while cash reserves remained elevated. We remain committed to a higher income accrual by building a higher coupon structure and working with BlackRock’s municipal research group to identify spread products that offer attractive valuations for their implied credit risk. We continue to favor names that are not subject to headline risk or the politics of austerity, which are mostly found in the more defensive sectors such as utilities and transportation. Given the expectation that interest rates will remain low for the foreseeable future, we believe that total return will continue to be derived more from income accrual than from price appreciation.
Important Risks of the Fund: The fund is actively managed and its characteristics will vary. Any holdings shown are provided for information only and should not be deemed as a recommendation to buy or sell the securities mentioned. Bond values fluctuate in price so the value of your investment can go down depending on market conditions. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers
to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment- grade debt securities (“high-yield bonds” or “junk bonds”) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable. The fund may use derivatives, such as futures, options, swaps or tender-option bonds, to hedge its investments or to seek to enhance returns. Investing in derivatives entails specific risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility.
The opinions expressed are those of the fund’s portfolio management team as of March 31, 2012, and may change as subsequent conditions vary. Information and opinions are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Reliance upon information in this material is at the sole discretion of the reader.
1 Institutional shares are sold to a limited group of investors, including certain retirement programs. Institutional shares are also sold to certain investment programs. Performance for Investor A shares prior to their introduction (10/21/94) is based on the performance of Institutional shares adjusted to reflect the fees applicable to Investor A at the time of such share class launch. This information may be considered when assessing the fund’s performance, but does not represent actual performance of this share class. 2 Lipper category is as of 3/31/12 and may not accurately represent the current composition of the portfolio. Lipper funds’ average returns are according to Lipper, Inc. Lipper General Municipal Debt Funds classification consists of all funds tracked by Lipper that invest at least 65% of their assets in municipal debt issues in the top four credit ratings. The Lipper Average reflects the average total return performance of those funds that make up the investment classification and does not take sales charges into consideration. 3 The S&P Municipal Bond Index is composed of bonds held by managed municipal bond fund customers of Standard & Poor’s Securities Pricing, Inc. that are priced daily. Bonds in the index must have an outstanding par value of at least $2 million and a remaining maturity of not less than 1 month. It is not possible to invest directly in an index.
You should consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and, if available, the summary prospectus contain this and other information about the fund and are available, along with information on other BlackRock funds, by calling 800-882-0052 or from your financial professional. The prospectus and, if available, the summary prospectus should be read carefully before investing. Unless otherwise noted, all information contained herein is as of the date of publication of this commentary.
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