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Fixed-Income Insights

In this second of two parts, we ask which factors could have the greatest influence on the performance of municipal bonds in the New Year? Here’s a look.

 

In Brief

  • Municipal-bond investors should be aware of five market characteristics that may affect the performance of tax-exempt securities in 2015:

  • -  Volume of new issue bond supply

    -  Issuer credit quality

    -  Relative value considerations

    -  The direction of interest rates

    -  Munis’ yield differential versus taxable bonds

  • The key takeaway— Along with the challenges of increased market volatility and the uncertainty regarding the U.S. Federal Reserve’s interest rate moves, investors need to be aware of the indicators specific to the municipal bond market that could positively affect performance next year and in the years to come.

 

In the previous Muni Matters, we examined three trends that influenced the municipal bond market’s slide in 2013—and its strong recovery in 2014. What are some of the market characteristics that should continue to affect muni bonds in the year ahead? Here, we’ll look at five important themes for muni investors in 2015.

1) Supply
New issues of muni securities rose over the final quarter of 2014, and total supply is on track to exceed $300 billion after a slow start to the year, according to data from the Municipal Securities Rulemaking Board. This is still below last year’s total, but the volume has been picking up and could continue to do so into 2015. With interest rates low, refunding bond deals also could increase as more outstanding issues move into the range where it is economical for issuers to refinance them.

The total supply of outstanding municipal bonds remains around $3.7 trillion, but during most recent quarters, net supply has been negative—meaning that more old bonds are being called out of the market than new ones being issued. This supports the prospect of continued strong demand for munis despite the appearance of higher outstanding supply due to a rising volume of new bonds being issued.

2) Credit Quality
On the credit side, there are more positives than negatives. For example, Detroit reached agreements with its creditors and exited bankruptcy in December 2014. All U.S. states are poised to balance their budgets without too much difficulty, although Illinois and New Jersey have had some struggles. Some states, such as California, are being lauded for how well they have used increased tax revenues (owing largely to a steadier economy) to shore up their finances.

Meanwhile, Puerto Rico appears to be trying to reinforce its general obligation credit while also leading its Power Authority bonds toward an expected restructuring. The commonwealth also is attempting to develop strategies to increase its liquidity and ability to finance itself. This is a mixed result for investors. So far, no Puerto Rico bonds have defaulted, despite all the heightened scrutiny from investors and the media, and the government does appear to have market access for potential new borrowings if it structures the deals appropriately. So, the Puerto Rico situation is still a work in progress. 

As of now, other than Puerto Rico, there are not any other large names on the horizon that appear to have imminent credit problems, so the negative headlines could continue to recede somewhat. As the U.S. economy remains in growth mode, tax revenues are rising, and dedicated revenues are increasing for bonds in many sectors, including transportation and education. 

Overall, municipals made it through the Great Recession without breaking their pattern of strong credit quality and low default rates. The trends remain positive in the credit rating outlooks for a range of sectors due to the positive performance of the economy.

3) Relative Value
The relative value of municipal bonds compared to other markets such as Treasuries remains attractive. Yields on long-term municipal bonds were recently higher than those of long-term Treasury bonds, despite their tax-exempt status, indicating value that could create increased demand. Municipal bonds that mature within 10 years also trade at yields closer to Treasuries than they were prior to the 2008–09 financial crisis. Overall, municipal bond mutual fund flows also remain solid.

One area that is difficult to analyze right now for market participants is the relative value of taking credit risk. There is one school of thought that looks at credit spreads since the 2008–09 financial crisis and concludes that spreads are tight because they are narrower than they have been over the past five years. The other point of view is to look at the spreads over a longer time period, which includes the years prior to the credit crisis. Under this analysis, credit spreads could appear to be wider than their historical averages, suggesting that there is still value in taking credit risk, despite the strong performance of lower-quality bonds over the past year. 

One part of the argument to support the second viewpoint is that the Federal Reserve had been buying tremendous amounts of Treasuries as part of its quantitative easing program since the credit crisis. But because the Fed stopped purchases in October 2014, the credit markets just might begin to look more like the pre–2008 environment because there will no longer be the dominant buyer of Treasuries, which possibly created an unnatural imbalance between markets. 

Another part of the argument is that the muni market has maintained its historically strong credit-quality profile through the post–financial crisis period, and investors have had time to adjust to the greatly reduced role of muni bond insurers in the market. (Pre-crisis, more than half of new muni-bond issuance carried insurance from these firms; now, the insurers’ market penetration now is below 5%.) Investors took time to get used to the higher supply of non-‘AAA’ rated bonds without the insurance, and the market had to adjust to how much incremental yield would be possible without this protection. 

Spreads may have widened initially as investors were unsure about trading municipal bonds without insurance, but after a multiyear adjustment period, the liquidity premium has been reduced, allowing market spreads to continue tightening. So, there could be an argument to suggest that taking credit risk in the municipal bond market could be an opportunity to take advantage of attractive relative value compared with pre-credit crisis levels.

4) Interest Rates
Overall, since municipal bond market credit quality concerns are not as great as they were a year ago, a major current focus for many investors is the low interest-rate environment and the potential for rates to head higher. This was a big concern over the last half of 2013 as well, which led many to withdraw money from bond funds. Of course, total returns have been very strong this year for municipals, so those who sold munis based on those rate fears, they lost out on the rebound. 

While no one can consistently be successful in calling interest rate moves, there are several factors to consider right now that could support the notion that interest rates may not rise as much as expected: 

  • Inflation is extremely low and shows no signs of increasing. 

  • Economic growth is steady, but there are no statistics creating any expectations for acceleration in gross domestic product (GDP) over the next year. 

  • Globally, major entities such as China and the eurozone are either lowering rates or thinking of adding quantitative easing to create more stimulus. With rates falling in other countries there could be a limit on how much U.S. Treasury yields can increase. 

  • Most forecasts suggest that any move by the Fed to raise interest rates is on hold until at least the third quarter of 2015. 

  • As we pointed out earlier, muni yields are higher than Treasuries and that the net supply of bonds is expected to remain negative. Those factors could continue to support the market compared with other fixed-income markets if indeed interest rates are raised. 

  • If then interest rates do rise, it could suggest that the U.S. economy is improving—which would mean that credit quality would be improving as well. This would support markets that have credit risk, such as municipals. In particular, the high-yield segment of the muni market could see upgrades in credit quality.

5) Yield Differential
Similar to where the market stood at the end of 2013, late 2014 presents of the more attractive times to invest in municipal bonds when considering many other historical points. One reason is the yield differential between taxable and tax-exempt bonds. Why? Last year, income tax rates rose at the federal level. A primary effect of the rate increase was the immediate increase of tax-equivalent yields for municipal bonds. (Tax-equivalent yield is the calculation of the incremental yield that is needed on a taxable bond to match the yield of a municipal bond given the tax benefit.) The differential has grown since then, meaning that a taxable bond needs even more incremental yield to get a similar return. For example, if a municipal bond has a 4% yield, for an investor in the 35% tax bracket, the tax-equivalent yield is 6.15%. In the 40% tax bracket, the tax-equivalent yield is 6.67%.

Further, the ratio of municipal bond yields to Treasury yields has remained high compared with pre-2008 levels, even though it is not high compared with ratios since the crisis. With income tax rates higher, the Fed having ended its bond buying program, and the underlying credit quality improving, these changes all support the potential for the yield ratio of municipal bonds to Treasuries to fall.

Summing Up
The dynamics of the municipal bond market have changed considerably over the past few years. Market participants and investors need to recognize the changes—and be able to adapt accordingly. A big part of this is to realize that volatility likely will be higher in the coming years, giving market swings the potential to be even wider. With any luck, some of this volatility can be reduced if investors can adjust and not overreact to new information. 

Although interest rates are low, there are still many reasons to continue investing in municipal bonds, and their relative value compared to other investments can be viewed as being attractive in the current environment. When looking at long-term performance, the municipal bond market has thrived over the past few years, despite having some volatile moments. Munis continue to offer the combination of high credit quality and strong tax-equivalent returns to investors. They also have continued to maintain the characteristics of having extremely low default rates and high ratings throughout the full credit cycle. [Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.]

 

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