Calvert News & Commentary

Current Interest Rate Environment Attractive for Calvert Tax-Free Bond Fund

11/16/2009

Tom Dailey, VP and
Portfolio Manager

Calvert Tax-Free Bond Fund is a tax-advantaged fixed-income fund that seeks to maximize income that is exempt from federal income taxes and to preserve capital by investing in a variety of tax-exempt obligations. Tom Dailey, Vice President and Portfolio Manager with Calvert Asset Management Company, Inc., recently shared his views on the municipal market and outlook for Calvert Tax-Free Bond Fund.

The investment objective for Calvert Tax-Free Bond Fund allows greater investment flexibility than its predecessor funds. How does this affect your approach to managing this portfolio?

The Fund is free of maturity and geographic restrictions, so we plan to be more active across the entire range of municipal market securities and yield curve in order to take advantage of sectors and maturities offering attractive investment opportunities.

We will be constantly monitoring the portfolio to take advantage of opportunities to adjust duration, sector weightings, credit quality and other factors based on our interest rate outlook. Our outlook is based on a number of criteria, including monetary policy, municipal supply, seasonal factors, market trends, shape of the yield curve and relative value.

We can also benefit from Calvert Tax-Free Bond Fund’s larger combined asset base, the result of a merger on July 31, 2009 of three of Calvert’s tax-advantaged fixed income portfolios, by taking advantage of larger block sizes in new and secondary market offerings and potentially improved buy/sell execution and pricing. This can result in more aggressive bidding when securities are sold.

While our strategy entails greater flexibility, preservation of capital, while maximizing income that is exempt from federal income taxes, remains the Fund’s goal.

Explain Calvert Tax-Free Bond Fund’s duration strategy.

For starters, duration is a measure of a portfolio’s sensitivity to changes in interest rates. The longer the duration, the greater the price change relative to interest-rate movements. Currently, the Fund’s duration is slightly below the 5.74 years of its benchmark, the Barclay’s Capital Municipal Bond Index. Calvert Tax-Free Bond Fund had an average duration of approximately 4 years back at the time immediately following the July 31, 2009 merger of three Calvert tax-advantaged fixed income portfolios. In the current environment of rising municipal rates, however, we have begun to move the Fund’s duration toward that of the benchmark to capture attractive longer-term yields.

Which sectors do you find attractive and unattractive right now and why?

Currently, Calvert Tax-Free Bond Fund is overweight in pre-refunded bonds and general obligation bonds, which offer high credit quality and liquidity. We have also increased our exposure to investment grade hospital revenue bonds because we feel that they offer attractive yields on a relative value basis. In terms of underweighting, at this time we are underweight leases and Certificates of Participation (COPs), a commonly used form of lease purchase financing, as we are concerned that the current state of the economy may cause disruptions to annual appropriations, which could affect the municipality’s ability to complete projects. For more details on Calvert Tax-Free Bond Fund’s industry market weightings as of September 30, 2009, please refer to the Fund Profile.

What is your credit quality approach for Calvert Tax-Free Bond Fund?

The average credit quality for the Fund is currently “AA”. We anticipate the average credit quality will range between “AA+” and “A-“. While the Fund may invest up to 35% of assets in non-investment grade securities, the Fund typically holds between 5% and 20%.

Are you pursuing a hold strategy for securities that were in the predecessor funds or are you following an active transition strategy?

Since the merger of funds into Calvert Tax-Free Bond Fund, we have been repositioning the Fund while being sensitive to the impact of any sales or purchases on the Fund. The municipal yield curve remains quite steep, with an approximately 350 basis point spread between 2- and 30-year yields. In addition, the current ratio of long-term municipal yields to taxable Treasury yields is high at over 100% (versus the current ratio of short-term municipal yields to Treasury yields, which is about 75% and is more in line with historical averages).

To take advantage of these opportunities, we have been carefully reducing the Fund’s exposure to shorter-term municipal securities and using the proceeds to purchase attractively priced longer-term municipals. From a price-return point of view, we feel that provides a more substantial cushion in a rising-rate environment. If Treasury interest rates increase evenly across the yield curve, longer-term municipal yields would not need to rise in the same proportion to restore the ratio of municipal yields to Treasury yields at historical norms of around 75% to 85%. Shorter-term municipals, in contrast, are already near historical averages for municipal-to-Treasury yield ratios, so we would expect their yields to move higher in roughly equal proportion with an increase in Treasury rates. Investors should keep in mind that bond yields and bond prices move in opposite directions.

In addition, we expect that, when interest rates do increase, short-term rates will climb much more than longer-term rates, flattening the steep yield curve and providing another advantage to holding longer-term municipal bonds. Finally, with yields where they are currently, long-term municipal debt provides substantially more income than short-term municipals.

Sectors that we have been moving into include general-obligation bonds with high credit quality, water and sewer bonds, and higher-education debt. Finally, we are actively working on an ongoing basis to reduce the Fund’s exposure to the illiquid securities held in the portfolio (8.84% of Fund as of 10/31/2009).

Do you see continued robust demand for municipal bonds?

We continue to see steady market demand for tax-exempt bonds. This has been driven in large part by the success of the taxable Build America Bonds (BABs), which has led to a decrease in tax-exempt bond issuance, particularly in longer-term maturity securities. As the Federal Reserve continues to hold short-term rates steady, investors have been going further out on the yield curve, and further down the credit quality ladder, in search of higher yields, fueling further demand.

Municipal securities have had a long and historic run this year. Near term, the rally appears to be running its course, and we expect that it will not continue at its current rate. This is due in part to a pick up in supply, which is having a greater impact on liquidity than in the past as a result of a reduced number of broker/dealers in the market. Broker/dealers at this time are unable to carry large inventories of bonds, so they will typically back up their bond bids when rates are rising in conjunction with supply.

Long term, we expect to see demand continue to grow as more baby boomers enter the retirement years and look for dependable sources of income generation. If, as many expect, federal income tax rates rise, then the value of the tax exempt component of municipal bonds will also increase, which would help to keep demand strong.

In conclusion, we anticipate that volatility in the municipal bond markets will remain high and is likely to provide strategic opportunities for investment managers such as Calvert to create value for investors.

Mutual funds that invest in bonds are subject to certain risks including interest rate risk and credit risk. As interest rates rise, bond prices generally decrease. The prices of long-term bonds are more sensitive to changes in interest rates than the prices of short-term bonds. Therefore, in general, long-term bonds have more interest rate risk than short-term bonds. In addition, the credit quality of the securities may deteriorate, which could lead to default or bankruptcy of the issuer where the issuer becomes unable to pay its obligations when due. The Fund may invest up to 35% of its net assets in below-investment grade bonds, which involve greater risk of default and price volatility than investment grade bonds. The Fund is non-diversified and may be more volatile than a diversified fund. There is also a risk that the Fund’s portfolio management practices might not work to achieve their desired result.

Keep in mind, some income generated by municipal bond fund holdings may be subject to state and local taxes and to the federal alternative minimum tax.