Considerations for Investors in Today's Municipal Bond Market
Retail investors seeking individual bonds may have missed out on the recent rally. Here are some considerations for the days ahead.
Read time: 4 minutes
After a difficult March, when the Bloomberg Barclays Municipal Bond Index fell 3.7%, the index rallied and, as of July 23, was up 3.4% for the year. The high yield municipal market had an even worse March, but it has been rallying since mid-May, and, as of July 23, it was down only -0.6% for the year. The volatility provided municipal bond buying opportunities, but it is an open question whether individual investors have been able to capitalize on them.
As with other asset classes, municipal bonds can be bought in both the primary and secondary markets. In the primary market, new offerings are brought to market by many firms, so to access the full universe of available issues, an investor needs to have relationships with many firms.
In the secondary market, bonds are available from a wide variety of dealers. Well over 100 dealers are active in this market, including on a few electronic venues. So, as in the primary market, to see all the offerings, it is necessary to maintain many dealer relationships. Access to these relationships, as well as the ability to buy in bulk, also enables institutional investors, such as mutual funds, to obtain very attractive prices, an potential advantage lacking among individual investors seeking individual bonds.
New Tax-Exempt Issuance Is Down, Inventories Are Scarce
In the primary market, opportunities to invest in new tax-exempt issues this year are down. According to The Bond Buyer, new bonds totaled $198 billion through June, up from $173 billion for the same time last year. But tax-exempt issuance has totaled only $143 billion, down 3% from the same period last year. This impacted some sectors more than others. Transportation, which traditionally provided a little more yield, has seen less issuance, while healthcare and education saw substantial taxable issuance. Thus, opportunities to invest in new tax-exempt issues have been limited.
With tax-exempt issuance down, has the secondary market offered better opportunities? If you were willing to buy in March, when prices were plummeting, the answer is yes. But if you waited until April or later, the answer is likely no. This may be especially true for individual investors.
There are two reasons for this. First, dealer inventories are very low. Regulations are tighter and dealers are no longer willing to take the risk that they did prior to the 2008 credit crisis. As of July 1, inventories totaled about $7 billion (for maturities of one year and longer), much lower than the $15 billion they averaged over the last five years (See Figure 1). Low inventories mean fewer options are available, especially for individual investors, who typically lack access to a wide range of dealers.
Figure 1. Dealer Inventories Have Declined
Dealers are less willing to carry large inventories of municipal bonds
Source: Bloomberg data as of July 15, 2020. Dealer holdings of Variable Rate Demand Notes (VRDNs).
Second, municipal bond mutual fund flows have been strong. Since mid-April, when outflows stopped, more than $20 billion poured in. But because supply in the primary market is down, funds have focused on the secondary market, snapping up the most attractive issues. So even when bonds enter dealer inventories, attractive ones don’t stay long. The same goes for bonds in the new issue market. Because fund inflows are so strong, new issues are typically oversubscribed, so often little is available later in the secondary market. Because bonds are being purchased and not re-traded, market volumes have been on the lower side, limiting availability.
Some Individual Investors in Municipal Bond Funds Have Benefited
So, have individual investors been able to participate in the market rally? If they were already invested in a municipal bond mutual fund, they have. These funds only had to buy incrementally when they received inflows. Individual investors with separately managed accounts also participated, as institutional managers can access the full range of opportunities and can quickly buy in bulk.
On the other hand, individual investors seeking to buy individual bonds likely faced challenges. It has been especially difficult for individuals in the high yield market. Once again, those with the conviction to buy individual high-yield bonds during the turmoil of March have done well we believe, but as mutual fund flows stabilized, selling has slowed and bonds available to individual investors have been scarce.
Municipal Bond Momentum
Consider these high yield bonds, which have performed well but have seen only a few large trades, strongly suggesting the buyers were institutional investors, not individuals. International Leadership, a charter school in Texas, is non-rated, with a 6 1/8% coupon and a 2048 maturity. These bonds have rallied about 8%. But even with $195 million outstanding, there has been only one trade since May 1, and it was for $10 million.
Or consider a California housing bond deal called Serenity at Larkspur. It is also non-rated and has a 5% coupon with a 2050 maturity. These have rallied about 14% since May 1. But out of a $220 million maturity, there have been only three trades during this time, totaling $19 million.
Moving up in quality, Hawaiian Electric Company, rated Baa2 by Moody’s, with a 3.20% coupon and a 2039 maturity, has rallied about 10% since May 1. But out of a $150 million maturity, only about $1.5 million have traded.
Certain issues have been more available, but these have been those that are typically less suitable for individual investors. These include, for example, Buckeye Tobacco bonds, Puerto Rico COFINA sales tax bonds and those from large corporate issuers, such as AMG Vanadium. But the frequency (should this be infrequency? Should be frequency, they trade more) of trading in these bonds can cause their prices to be much more volatile with prices falling more than 30% at the worst points of March. So, although these bonds can be effective in a diversified portfolio, in individual portfolios, which tend to be less diversified, they may be less suitable.
Of course, in addition to having access to the full range of available bonds and being able to obtain optimal prices, institutional buyers also typically have the ability to create diversified portfolios and use specialized skills to assess pricing and analyze credit risk. On the other hand, individuals seeking individual bonds, who are not able to follow the market full-time, lack these advantages.
Although the municipal bond market has recovered, the scarcity of available bonds has made it challenging for those seeking individual bonds to fully participate in this recovery. On the other hand, those who have been invested with institutional buyers such as mutual funds are more likely to have benefited. Today, even with the recent recovery, yields still offer relative value versus other markets, especially in the high yield muni market. But for most individuals, we believe the best way to fully participate in rallies like the one we have seen since April is to invest in a municipal bond mutual fund.
A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Lower-rated investments may be subject to greater price volatility than higher-rated investments. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Investments in Puerto Rico and other territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.
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