The municipal bond market emerged unscathed from turmoil in financial markets over the past two weeks. Despite a pullback in the stock market and gyrating Treasuries, municipal bond prices and yields were relatively stable. Since the start of May, the 10-year Treasury yield fluctuated between a 3.39% and 3.68% yield, the average AAA-rated 10-year municipal yield held in a narrow 3.14% to 3.20% range, according to Moody’s. The steadyeddy demeanor also extended to the municipal high-yield market, which outperformed high-quality municipal bonds month-to-date through May 17, 2010, as measured by the Barclays Municipal Bond Index and Barclays Municipal High-Yield Index. The outperformance of Municipal High-Yield Bonds is in sharp contrast to the taxable high-yield bond market, which underperformed Government Bonds notably so far in May. Two factors explain why municipal bond prices held steady during recent market turmoil:
- The municipal market suffered a pullback of its own from mid-March through early April. Tax season is a traditionally difficult period for municipal investors as investors sell bonds to pay taxes. A surge in bond supply from new issuance and investor selling caused high-quality bond prices to decline. As April 15 passed and supply moderated substantially, the municipal market regained its footing. A manageable new issuance calendar to start May along with still strong demand for tax-free income helped keep the municipal market stable.
- Moody’s and Fitch recalibrated their municipal bond ratings. While we would consider ratings recalibration that resulted in thousands of Municipal bonds having their ratings recalibrated one to three-notches higher a secondary factor, it nonetheless increased the attractiveness of the asset class to a broader range of high-quality bond investors. Challenges on the horizon may alter the blissful municipal bond market environment, however. June 30 is the fiscal year-end for most states and that means budget season is just around the corner. The process of balancing budgets is likely to be accompanied by political wrangling. Municipal credit concerns remain at the forefront of news headlines and any delay in getting budgets balanced or increased political rhetoric may only serve to increase negative headlines. An escalation of credit fears may undermine investor confidence and lead to weaker prices and higher yields.
Maturing Bonds on the Way
June is also one of the biggest months for maturing bonds and marks the start of the June-July redemption period. New issuance typically increases as municipalities roll over the majority of maturing bonds. July has typically been one of the better months for municipal bond performance, as supply tapers off and investors more actively reinvest cash from maturing bond proceeds. However, the first half of June has often witnessed weakness as market participants assess whether investor interest is enough to match the new bond supply and gauge the right time to reinvest.
The budget process and the start of the June-July redemption period could combine for a one-two punch to knock down municipal bond prices. On the positive side, the net decline in Treasury yields coupled with relatively unchanged high-quality municipal bond yields has improved municipal valuations relative to Treasuries. The higher municipal yields are as a percentage of Treasuries, the more attractively valued Municipals are relative to Treasuries and vice versa. We believe the cheaper valuations, if not immediately reversed, would act as a buffer to any municipal market weakness.
We would view weakness as an opportunity to consider municipal bond exposure, as we remain favorable on the longer-term prospects of the municipal bond market. First and foremost, tax rates are set to increase at the end of 2010, barring any action in Washington, with the top marginal tax-bracket increasing to 39.6% from 35%. This has the effect of increasing the attractiveness of tax-exempt income. Second, the favorable supply-demand balance is still in effect as the Build America Bond (BAB) program continues to siphon away issuance from the traditional tax-exempt market and into the taxable market. Through the end of April, year-to-date traditional tax-exempt issuance was 20% lower compared to the same period in 2009.
How Fearful Are You?
Last, but not least, we believe municipal credit quality fears are vastly overstated. Budget discussions may raise concerns about default risks should budgets get delayed or politicians raise the threat of bankruptcy in an attempt to sway opinions. Investors should be thankful that 49 states, unlike countries, are required to balance budgets every year, thereby reducing the risk that budget deficits grow out of control such as in Greece. Take, California, for example, the poster child for state budget issues, whose $18 billion deficit over the coming two years is merely one percent of the state’s Gross Domestic Product (GDP – a measure of economic output). Contrast that to Greece, which has a budget deficit of 13% relative to GDP. Additionally, California’s outstanding debt amounts to roughly 4% of the state’s GDP compared to Greece’s current debt-to-GDP ratio of 115% that is expected to increase to roughly 145% of GDP.
We believe the budget process will result in tough decisions and painful cuts to services, but not defaults. We would view any weakness as an opportunity to consider high-quality general obligation (GO – tax supported) and essential service revenue bonds. Defaults have been very rare in these sectors and we believe that will continue to be the case.
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
- International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- Municipal Bonds are subject to availability, price and to market and interest rate risk is sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxed may apply.
- The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. All indices are unmanaged and include reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of future results.
- The Barclays Capital High Yield Municipal Bond Index is an unmanaged index made up of bonds that are non-investment grade, unrated, or rated below Ba1 by Moody’s Investors Service with a remaining maturity of at least one year.
- The issuance of Build America Bonds (BAB) began in April of 2009. They were authorized by the ARRA economic stimulus of 2009 and can be issued for qualifying infrastructure projects. They are taxable municipal bonds and are considered a category of bonds.
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