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Fixed-Income Insights

In this first of two parts, we look at the factors that influenced this year’s recovery in the municipal bond market after a dismal 2013.

 

In Brief

  • After a difficult 2013, the municipal bond market staged a strong recovery in 2014. We’ve identified three potentially long-term trends that could have influenced both the market’s rebound and its decline last year:

  • - the emergence of so-called crossover buyers as a force in the market;

    - changes in market dynamics because of new financial regulations; and

    - Increased scrutiny of the muni market by financial media.

  • The key takeaway—While these trends could continue to affect the short-term volatility of the muni market in the years to come, investors also should focus on the continuation of a more important long-term trend: that the historically strong credit quality and low default rate among muni issuers has been maintained through this market cycle.

 

What a difference a year makes. Given the unsettled state of the municipal bond market in late 2013, many investors might be very confused—or, more likely, pleasantly surprised if they maintained their holdings—by where the market stands near the end of 2014.

During the last few months of 2013, the market faced a number of challenges. Muni bond mutual funds were experiencing significant outflows. Puerto Rico, an important muni bond issuer, was experiencing fiscal distress, with many investors speculating that its problems would carry over to the rest of the United States. And finally, there was almost unanimous agreement that interest rates were poised to rise considerably during 2014. 

Better Tidings
But the calendar turned to a new year, and with it so did the fortunes of the muni market. Fund flows changed course as soon as 2014 started, and the concerns about potential declines in issuers’ financial health and rising interest rates did not come true. Overall, 2014 has been a very strong year for the municipal bond market, and it has provided evidence once again that munis are a good place for long-term investors to allocate a portion of their assets.

Indeed, the total return numbers for key municipal-bond categories look very strong as 2014 winds down. Long-term investment-grade and high-yield muni funds achieved double-digit total returns, according to data from Morningstar, while intermediate-term funds returned as much as 7.5%. And these total return numbers do not even factor in the tax-equivalent yields characteristic of municipal bonds.

Issuer credit quality has generally remained near historically strong levels. Even California, whose fiscal standing was the subject of critical media commentary a couple years back, was upgraded this year by major credit rating agencies, into the ‘AA’ range. Meanwhile, investor demand, as measured by ICI data on municipal bond mutual fund flows, has been positive throughout the year.

Three Key Trends
When reviewing muni market performance over the past couple of years, it is clear that investor sentiment has changed rapidly at times. This has led to outsized performance in both negative and positive directions. During this time, three trends have developed, which are now significantly affecting market performance. Each of these issues has both positively and negatively changed the market while also increasing volatility. These trends are likely to influence the market for years to come, so it is useful for investors to understand them in order to incorporate them into future expectations for the muni sector.

1) The Emergence of Crossover Buyers
Over the past few years, traditional muni buyers such as mutual funds and insurance companies have continued to participate in the asset class. But recently, munis also found strong demand from hedge funds and a group known as crossover buyers—that is, investors who typically select securities from a wide range of categories, including taxable bonds, but are choosing to “cross over” into the municipal bond market. These buyers primarily focus upon the total-return potential of municipals rather than the tax-exempt income they offer.  

What sparked the increased interest from crossover buyers? The Build America Bond program, which started in 2009, boosted the volume of taxable municipal bonds as part of the federal stimulus plan in response to the credit crisis of 2008–09. This prompted more investors to familiarize themselves with municipal issuers in order to become comfortable with the market.

These buyers soon put their newfound knowledge of the market to work. Several periods of fund outflows over the past few years have created good opportunities for crossover buyers to place attractive trades. During these episodes, all funds typically experienced outflows at the same time, and have needed to raise cash for their shareholder withdrawals. When they need to find a buyer, this liquidity has often been provided by crossover buyers at below market prices that typically have rebounded when the direction of fund flows changed and funds started buying again instead of selling.

2) Increased Regulation
The second trend has been increased federal government regulation of the financial industry and increased government agency focus upon the muni market. While this has led to many positive developments, including guidelines for increased issuer disclosure, one particular consequence of the new regulatory focus has been to reduce banks’ ability to take risk. This has led to decreases in the sizes of their inventories of fixed-income securities--and their ability to make markets in bonds, including muni securities. As a result, the impact of crossover buyers has been heightened, especially in down markets, and market volatility has increased, as was apparent during 2013 in reaction to the outflows. 

Unlike dealers who are making markets for long-term clients and sometimes supporting markets, crossover buyers, with a typically shorter investment horizon, are mostly interested in extracting the maximum amount from each trade at times when they know mutual funds have no choice but to sell.  Since the regulations limit the amount of securities that dealers can add to their inventories, the crossover investors often do not have much competition when trying to buy bonds in down markets.  This makes prices decrease faster as funds face outflows, and rebound faster as inflows occur because these investors are quickly marking up prices in response to heavy demand. Fund flows are tracked closely by third-party services so the information is easily available to short-term traders, and they can then quickly adjust their bids or offers in the market. 

While the ability of crossover buyers to provide liquidity in down markets, and can step in for banks as a source of providing inventory in up markets, is an overall positive, this development has dramatically changed the dynamic of muni market volatility.

3) Greater Media Focus
The third trend—increased media scrutiny of the municipal bond market—also added to volatility. During the 1990s, the municipal bond market did not receive a lot of attention, so the information flow was not as rapid and, arguably, not as prone to speculative press coverage. Now, many news services dedicate resources to tracking municipal bond market information while investors are getting news updates throughout the day. Over the past year, the Puerto Rico situation has been an example of an issue that caught the media’s attention and continues to be actively reported upon. Other issues, including Detroit’s bankruptcy and the health of state pension systems, have garnered similar attention. 

To be sure, these situations have been developing for years, and it likely will be some time before we will have any indications that they will be fully resolved. Over short time periods, though, intense media coverage of these matters can raise investor concerns in response to the uncertainty. In 2013, for example, the media attention, especially with regard to Puerto Rico’s fiscal situation, had a significant negative impact upon investor sentiment and likely contributed to significant outflows from muni bond funds. Although Puerto Rico’s financial issues are definitely significant, this attention and market reaction were somewhat reminiscent of analyst Meredith Whitney’s inaccurate characterization of the overall health of muni issuers in late 2010, which also led to some market volatility.

By comparison, things have been much calmer in 2014. This year, as the negative headlines have turned more positive, and thus we have more clarity on the muni market’s main challenges, the dynamic has changed. Indeed, much of the press coverage these days centers on the muni bond market’s 2014 recovery.

Summing Up
Our purpose in identifying these trends is not to offer an opinion on whether they are good, or bad, for investors, but instead to help describe what we think are lasting changes to the municipal bond market environment. A look at these drivers of market activity can help us understand why total returns were weak in 2013, but rebounded sharply in 2014.

What’s important to remember is that through it all, the historically high credit quality of the municipal bond market remained consistent, along with the extremely low issuer-default rate. This means that the fundamental qualities—and benefits—of the asset class have not changed, despite the episodes of market volatility. As a result, after time passed and short-term traders completed their strategic changes, the market recovered because investors realized that the well-publicized concerns about the muni market had been overblown.

Next: “Five Developments to Watch in 2015.”

 

Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. Instances of high double-digit returns were achieved primarily during favorable market conditions and may not be sustainable over time.

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.

A Note about Risk: The value of investments in debt securities will fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. Lower-rated investments may be subject to greater price volatility than higher-rated investments. Longer-term debt securities are usually more sensitive to interest rate changes, the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. 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. Puerto Rico and other U.S. 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. No investing strategy can overcome all market volatility or guarantee future results.

Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality ratings of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

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