Hospital, tobacco munis seen overvalued

NEW YORK (Reuters) - Hospital and tobacco municipal bonds are overvalued, but tax-exempt bonds overall can still richen relative to Treasuries, a muni portfolio manager said on Tuesday.

Thomas Metzold, who runs the $4.25 billion Eaton Vance National Municipals Fund and co-manages the firm's $1.1 billion High Yield Municipals Fund, said he was selling tobacco bonds because risks no longer justify the rewards.

"We are sellers of tobacco bonds," Metzold told the Reuters Investment Outlook 2007 Summit.

"How much tighter can they possibly get?" he said. "They are trading as if they are "AA" bonds and yet they are "BB" or "BBB" bonds, or "single-A" in the best instance."

Metzold, who is a candidate for Morningstar's 2006 Bond Fund Manager of the Year award, said he bought tobacco bonds when they yielded between 7 percent and 8 percent.

Now these securities, which are backed by revenues from a settlement between the states and major tobacco companies, yield less than 5 percent on the long-end, according to BondDesk.

Metzold said the credit spreads in the municipal and other markets are too tight. For example, hospital bonds that typically have low ratings yield just 40 basis points over high-grade bonds.

"Hospital bonds are very overvalued right now," Metzold said. "That's not to say if a bond at the right price becomes available we won't buy it, but in general, if somebody calls with a hospital bond, we are not going to be interested."

Metzold said the likelihood of further appreciation of hospital bonds is small. But the decline could be great, given that such paper used to trade at spreads as wide as 300 basis points 20 years ago, when he started his career in the investment management industry.

Yet Metzold was bullish on the municipal bond sector overall because of declining supply and increased likelihood of higher tax rates.

"You are going to see continued outperformance of municipals vis-a-vis Treasuries," he said.

There is a very strong demand for municipal bonds at a time when issuance is falling from the all-time record of over $400 billion in 2005.

Metzold said this year, municipal bond issuance could come in around $360 billion to $370 billion, and in 2007 it could be as low as $350 billion because most refinancing options by state and local governments have been exhausted.

At the same time, supply of Treasury bonds could increase, given deficits and a declining dollar.

In addition to that, Metzold said, the Democratic-controlled Congress may not be inclined to extend President Bush's tax cuts beyond the 2010 expiration date. That would make municipals more desirable and would push prices of tax-exempt bonds higher.