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Fixed-Income Insights

How could the Federal Reserve's reduction in monetary accommodation affect municipal bond yields in 2014?


In Brief

In 2014, the focus of the financial markets likely will be on the tapering of bond purchases by the Federal Reserve; within the municipal bond market, investors will be carefully watching tapering's potential impact on muni yields. Three factors likely will influence the muni market response:

  • Munis' relative valuation versus Treasuries—Measures of the ratio of long-term municipal yields versus those of Treasury securities have remained high since the Fed began its quantitative easing (QE) program. The ratio could fall as the Fed cuts back on its bond purchases.

  • The steepness of the muni yield curve—The yield spread between yields on short- and long-term munis is wide by historical standards. The yield curve is likely, eventually, to flatten should interest rates rise further, because it will lead to expectations that the Fed will start raising the fed funds rate, leading to an increase in short-term interest rates.

  • Credit quality of the muni market—The media focus on the issues in Detroit and Puerto Rico has raised investor concern about the credit quality of the entire municipal market. But over the past few years, key measures of muni issuers' creditworthiness have actually been improving.

  • The key takeaway—The tapering-related factors mentioned above could have a positive impact upon the municipal bond market's relative performance in 2014.


Market volatility. The default of Detroit. Worries about Puerto Rico's credit standing. Municipal bond investors certainly faced plenty of tough issues in 2013. While those topics will continue to resonate in 2014, we believe the key question for the year likely will be: What does Federal Reserve tapering mean for municipal bond yields?

To answer that question, it is useful to examine three individual factors that could determine how the muni bond market might respond to the reduction of monthly bond purchases by the Fed, which began in January 2014. They are 1) the relative value of municipal bonds versus Treasuries; 2) the muni market's overall credit quality; and 3) the spread between short-term and long-term interest rates on municipal securities.

Of course, these are not the only factors that could influence the market, which remains extremely susceptible to changes in supply and demand conditions. Also, any significant change in closely watched technical indicators could alter the market's tone. But it is quite possible that the three tapering-related factors mentioned above could have a positive impact upon the municipal bond market's relative performance and on the performance of securities with different maturities within the market. So let's examine each of the three factors.

1) Munis' Relative Valuation versus Treasuries
If Fed tapering causes interest rates to increase across all fixed-income markets in 2014, they will likely rise in the municipal bond market as well—but the response could be less pronounced. As a starting point, the Fed's tapering means fewer bond purchases in the Treasury and mortgage-backed securities' markets. The scale of the central bank's purchases of securities in the taxable markets has been distorting the relationship to the muni bond market, creating higher yield ratios of municipal bonds to Treasuries, as the Fed's QE program drove down yields of government securities. If the Fed slows or stops buying, it does not change the demand component for municipals, but it does for taxable bond markets.

Currently, ratios of municipal bond yields to Treasury bond yields are above historical averages for issues with maturities of 10 years and longer, while still being more than 100% for 30-year Treasury bonds. (See Chart 1.) This has been the case for most of the time that the Fed has been conducting its QE program. So, when the central bank slows down or stops buying Treasuries, there could be a positive impact upon the relative value ratios as Treasury rates rise. In turn, this could bolster relative returns in the muni market.

 

Chart 1. Munis' Yield Ratio Versus Treasuries Remains High

Yields of 30-year 'AAA' rated* municipals relative to the 30-year Treasury bond, December 1993–January 2014

Source: Thomson Reuters. As represented by Thomson Reuters Municipal Market Data.
* As rated by Standard & Poor's, Moody's, and/or Fitch. *30-year AAA muni yield divided by 30-year Treasury yield.

Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in 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.

 

2) The Steepness of the Muni Yield Curve

Another measure related to muni yields is also receiving scrutiny in the market. Yield spreads between short- and longer-dated muni bonds have been elevated since the Fed shifted the fed funds rate target to the 0–0.25% range in December 2008.

 

 

Table 1. Post-Financial Crisis, Yield Spreads Remain Wide for Short- and Longer-Dated Munis

Yield spread between specified maturities of municipal debt rated 'AAA' by Standard & Poor's, Moody's, and/or Fitch

Source: Bloomberg.
1 Last increase in the fed funds rate by the Federal Reserve: 6% to 6.25%.
2 Fed lowers target on fed funds rate to 0–0.25%.
Past performance is no guarantee of future results.
Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in 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.

 

What does this mean for muni investors? The yield curve is likely, eventually, to flatten should interest rates rise further, because it will lead to expectations that the economy is getting stronger and that the Fed might start raising the fed funds rate, leading to an increase in short-term rates. Last year, as interest rates rose, the opposite happened, because the yield curve actually grew steeper, not flatter, and it has remained near historically wide levels. By the time the Fed is finished with its tapering program, the yield curve could be much flatter than it is now because short-term interest rates are likely to start moving higher along with the tapering, and probably before the Fed takes action with the fed funds rate.

The current steepness in the yield curve, then, presents an opportunity for muni investors. Why? They may be able to pick up incremental yield for any kind of extension of the maturities in their bond purchases, representing a chance to gain more attractive, tax-advantaged income at an appealing price. This window likely will close with any significant flattening of the muni yield curve.

Another point to think about when analyzing interest-rate risk is that many investors use a duration calculation to determine the risk of a bond, so they view a bond with a five-year duration as having less interest-rate risk than one with a 10-year duration. While this will often be the outcome, most of the duration numbers published by financial information providers represent a price change calculated as if interest rates at all maturities move at the same pace. If the yield curve is flattening, interest rates would actually be moving up more for short- and intermediate-term bonds than those that have long maturities, so the duration calculation might not accurately reflect the relative interest-rate risk.

If the flattening of the yield curve is significant, it is possible that a longer-term bond might not fall as much in price as an intermediate-term security. This is something to keep in mind when thinking about how investments will perform in a rising interest-rate environment.

3) Credit Quality of the Muni Market
When the Fed started the discussion about tapering in May 2013, it caused long-term and intermediate-term bond yields to rise across most markets. As the year progressed, the municipal bond market saw interest rates rise even more due to the media focus upon the issues in Detroit and Puerto Rico. While some of the worries were justified, some were not, so the end result was concern about the credit quality of the entire municipal market.

A closer look at this issue, though, reveals another reason why municipal bonds could outperform in 2014: Over the past few years, key measures of muni issuers' creditworthiness have actually been improving.

Of course, the world of muni credit ratings weathered tremendous change during the 2008–09 financial crisis. One of the biggest changes was the diminished role of bond insurers in the market. Previously, many investors perceived muni credit quality to depend upon the 'AAA' ratings of the bond insurers rather than the underlying creditworthiness of the muni issuers. The percentage of new municipal bond issuance covered by the insurers peaked at 57% in 2005, based on data from Standard & Poor's. Beginning in 2008, the financial guaranty insurers became subject to credit rating agency downgrades, largely as a result of the insurers' exposure to residential mortgage-backed securities (RMBS). By 2013, the insured percentage had fallen to less than 4% of new muni bond issues.

With the reduced presence of bond insurers, the determining factor in setting muni issuer credit quality has been refocused upon issuers' underlying credit ratings rather than the enhancement from the bond insurers. Since that time, the trend has actually been to higher muni credit ratings rather than lower. This was primarily due to a reassessment of the asset class by ratings agencies, specifically Moody's, which led to the acknowledgment that munis had been underrated compared to corporate bonds of similar credit quality despite munis' historically lower default rates and higher recovery rates. This caused ratings to be moved up for many sectors, and caused underlying munis to have higher ratings on average. Standard & Poor's adjusted many ratings higher as well via a less formal process than Moody's. Although some ratings have been readjusted down as they have been reviewed over the past few years, these moves have been made selectively while the overall sectors have retained their higher ratings.

As the economy has rebounded from the recession, there have been other positive indicators as well. State tax revenues collected have increased every quarter for at least the past three years, according to data from the Census Bureau. Local government tax revenues have also been stabilizing over the past year as real estate values have been recovering. There has been a tremendous focus upon balancing budgets at all levels of government and changing criteria for those workers entering pension plans to reduce future burdens somewhat, so most state and local governments have improved their financial standing. With interest rates remaining low, state and local governments have also refinanced a lot of their outstanding debt, thereby lowering their borrowing costs. With governments striving towards more austerity, they have also limited their borrowing by not issuing as many bonds so they are not as heavily in debt.

The result? The percentage of municipal debt rated Aa2 or higher has increased. Therefore, it’s useful to compare ratings pre- and post crisis. (See Table 2.)

 

Table 2. Since the Financial Crisis, Muni Credit Quality Has Improved in Key Categories

Percentage of local general obligation debt rated 'Aa2' or higher by Moody's

Source: Moody's Investors Service. Data as of December 31, 2012 (latest available).

 

So, the combination of the credit rating agencies moving ratings higher to be more in line with their corporate equivalents and the improvement in the financial metrics suggest that the credit quality of the municipal bond market is improving, not becoming worse, as the media seem to be suggesting. Investor sentiment may have been dampened by press coverage of Detroit and Puerto Rico's credit challenges, which tends to emphasize the negative factors in those situations, while rarely mentioning any of the positive developments in those areas or across the country. Also, if the Fed does continue tapering, that means that it is confident that the U.S. economy is becoming better and, then, credit quality should be improving too. As credit issues get resolved with Detroit and Puerto Rico, investors may become convinced that the woes of both will not carry over to other municipal issuers. If that happens, the muni market could get a boost compared to other segments of fixed income, and it could lead to better relative performance.

Summing Up
Does the Fed tapering environment have to be negative for the municipal market? No. Rather, a rise in Treasury yields may improve the relative valuation of munis. And the relative value of municipals is still attractive versus other fixed-income markets. Further, the overall credit quality of the muni market has held up well, despite the trying times of 2013. Therefore, investors might do well to remember that the challenges of the current market can create opportunities in the months ahead.

 

 

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