In May, the market turmoil that grabbed and dragged taxable High-Yield Bonds to one of their worst monthly performances on record, according to Barclays data, did not stick to Municipal High-Yield Bonds. Seemingly immune to the volatile trading that occurred in the taxable high-yield market, tax-free high-yield bonds delivered positive total returns on all but four days during May according to Barclays index data. That trend has continued so far in June with lower-rated municipal bonds outperforming their taxable counterparts. Municipal High-Yield Bonds are the best performing bond sector year-to-date. In today’s financial markets where lower-rated bonds of all types tend to move in unison to market turmoil, the disparity between municipal and taxable high-yield bonds is particularly noteworthy. Three factors help explain the steadfastness of Municipal High-Yield Bonds while their taxable cousins fell victim to market volatility.
- A favorable supply-demand balance. As we have previously written, the entire municipal bond market, not just bonds rated below investment grade, have benefited from a favorable supply-demand balance. The Build America Bond (BAB) program has siphoned away new issuance that would have normally originated in the traditional tax-exempt market. Through the end of May, year-to-date traditional tax-exempt municipal issuance is almost 20% lower compared to the same period in 2009 and is on pace to finish 2010 at the lowest level in seven years. Supply is going down just before top tax rates will increase and likely spur further demand for municipal bonds. While the BAB program has a greater direct impact on high-grade municipals, it has contributed to lower overall high-grade municipal yields and forced income-seeking investors into the tax-free high-yield market.
- Municipal High-Yield Bonds typically lag the improvement in the taxable high-yield bond market. Following the 2001-2002 recession and
the ensuing corporate fraud scandals, the taxable-high yield bond market rebounded before the tax-exempt high-yield bond market. The average yield advantage, or spread, of High-Yield Municipal Bonds relative to AAA-rated municipal bonds peaked well after the peak in High-Yield
Bond spreads (to comparable Treasuries) in the early 2000s. Part of this is due to the lagged nature of how recessions affect municipal budgets.
Tax revenues are first reduced in the year after a recession hits and lead to budget cuts for the subsequent one to three years depending on the severity. While the height of financial market panic occurred during the fall of 2008, municipal budget shortfalls are expected to continue through next year. This helps explain why the taxable high-yield market improved more quickly, as evidenced by the sharper contraction in yield spreads, relative to Municipal High-Yield Bonds even though both markets bottomed at roughly the same time.
- Better valuations. Related to the point above, Municipal High-Yield Bond valuations are more attractive relative to taxable High-Yield Bonds. The 6.8% yield of the Barclays Municipal High Yield Index as of June 8, 2010 translates to a 10.5% taxable equivalent yield for an investor in the top 35% tax-bracket, above the 9.4% yield on the taxable Barclays High-Yield Bond Index. In addition, the average 6.8% yield on High-Yield Municipal Bonds is in line with its historic average, while the average yield of Taxable High-Yield Bonds is elevated at 9.4% it is below the long-term average of 10.8%.
Bonds Will Be Maturing
The month of June presents some challenges to Municipal High-Yield Bonds that may crack the shield surrounding the sector. First, the month of June is one of the largest months of bond maturities in the municipal market. Historically, the first two weeks of June have often witnessed municipal bond weakness as investors sit on the sidelines and assess the degree of new issuance that may result from municipalities reissuing, or rolling over, maturing debt. A surge of new issuance that does not meet sufficient investor demand may push bond valuations lower. This phenomenon occurs primarily among higher-rated bonds, but weakness in high-grade bond prices would likely reverberate into High-Yield Municipal Bonds as well.
Secondly, the end of June represents the end of the fiscal year for most states and the budget balancing process could increase negative headlines. Most state budgets remain under pressure and politicians from both parties will likely cite the severe ramifications of cutting, or not cutting, services and raising fees and taxes. While municipal budgets have certainly been in the news, headlines could reach a feverpitch and municipal credit quality fears could escalate. Any nervousness that results from budget news could weigh on municipal high-yield bond prices.
Favorable on Municipal Bonds
However, over the longer-term we remain favorable on Municipal High-Yield Bonds and continue to find them attractive. While defaults will likely
increase, we believe they will remain concentrated in the most speculative of municipal bonds – non-rated housing-related issues that were to be repaid by fees assessed from would-be homeowners. Many of these projects were never completed and bonds have subsequently defaulted. We believe an active investment manager can sift through the high-yield market and find attractive opportunities. The average yield spread to AAA-rated municipal bonds remains well above the historical average, which is 2.4%, and the average yield of 6.8% will help provide a cushion when interest rates eventually rise. Furthermore, the Rockefeller Institute of State and Local Finance recently announced that state revenues overall increased on a year-over-year basis during the first quarter of 2010 for the first time since the third quarter of 2008. While many states still suffered revenue declines we view the data as a sign that municipal credit quality is in the process of bottoming. Finally, the prospect of higher top-tier tax rates at the start of 2011 may provide an additional lift.
- 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.
- 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.
- High-yield/junk bonds are not investment grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.
- The Barclays Capital High Yield Municipal Bond Index is an unmanaged index made up of bonds that are noninvestment grade, unrated, or rated below Ba1 by Moody’s Investors Service with a remaining maturity of at least one year.
- 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.
- This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
- 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. AAA-rated bonds are measured by Moodys.