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Fixed-Income Insights

While volatility has dominated the headlines, a closer look at recent developments points up the positive underlying characteristics of the muni market.

For municipal bond investors, the recent market sell-off—mainly sparked by fears that the Federal Reserve will begin to withdraw some monetary stimulus at some point in the near future—might have been an unwelcome stroll down memory lane. Specifically, investors might have been worried about a reprise of the extended market dislocations that occurred between 2008 and 2010.

The recent selling was sharp, and swift, especially for long-term bonds. The Barclays Municipal Long Bond Index, for example, shed 4.4% in June 2013, its worst monthly decline since September 2008, according to Bloomberg. Investors pulled a record $4.5 billion out of municipal bond funds in the week ended June 26, 2013, according to Lipper data.

The June declines capped a dismal second quarter of 2013, in which the municipal market posted a return of -3.4%, according to Bank of America Merrill Lynch data. That was the biggest quarterly decline since the final three months of 2010, when banking analyst Meredith Whitney issued her now-infamous forecast of "hundreds of billions of dollars" of muni defaults, according to Bloomberg. Whitney's forecast helped propel 29 straight weeks of fund outflows.

The comparisons with the 2008–09 financial crisis and the later Whitney episode are telling. In each instance, the muni market was whipsawed by investor fears that were by and large divorced from actual market fundamentals. Even during the 2008–09 credit crisis, investment-grade municipal bonds did not experience any material increase in defaults, with the main credit difference being credit rating downgrades to bond insurers due to issues that were separate from the municipal bond market. In both cases, the market was able to stabilize—and, subsequently, deliver positive returns, though there is no guarantee that this trend will continue in the future.

It would be easy to say that the most recent sell-off has uncovered opportunity for savvy investors, with relative valuations versus Treasuries reaching attractive levels and with yields rising to levels representing value for potential buyers in all tax brackets. And that certainly appears to be true. But perhaps it would be more useful to look at the bigger picture: how the muni market performed during the recent downturn, and what investors should know about some of the positive indicators arising from the market action.

With that in mind, here are five important takeaways from the recent "emergency test" of the muni market:

1. The muni market remained resoundingly liquid.
During the four-week period through June 26, 2013, weekly outflows from municipal funds were, respectively, $1.6 billion, $1.4 billion, $2.2 billion, and, finally, an eye-popping $4.5 billion, according to Lipper. When investors requested redemptions, the market was equipped to handle them, with asset managers finding enough liquidity to handle $10 billion in outflows from municipal bond funds over the four-week period.

To be sure, there were some challenges. While liquidity was always available, at times there was a significant cost necessary to find a buyer, and that created a significant penalty for those wanting to sell. Still, it is important to remember that there were buyers to handle the volume of outflows. Bid-wanted volume, which captures the amount of bonds listed for sale through competitive auctions, was very high, according to Bloomberg, so there was a lot of competition for liquidity. In the end, mutual funds were able to raise the necessary cash, and the liquidity allowed investors to withdraw their money if they needed it. Eventually, as yields rose, they became high enough to significantly increase demand to the point where the market started rallying back and losses were capped, at least for that time period.

2. At the right prices, buyers were waiting in the wings.
As everyone was hoping, heavy demand from individual investors began to emerge when yields for investment-grade bonds hit 5%. As an indicator, the Bond Buyer Revenue Bond Index yield was marked at 4.91% on June 27, 2013, which was the highest it had been since the first week of 2012, according to The Bond Buyer. The yield had been as low as 4.06%, as of December 6, 2012. Indeed, yields on some 20- to 30-year 'AA' and 'A' rated bonds reached above the 5% milestone during the week prior to June 27, 2013, according to Bloomberg. Bonds with 5% coupons priced at a slight discount to par proved attractive to retail buyers, so prices did not stay at the highest yields as long as investors were buying actively.

Lending further appeal, the tax-equivalent yields at higher yield levels were attractive, particularly given the increases in individual income tax rates that occurred at the end of 2012. For example, for an investor in the 35% tax bracket, a 5% tax-exempt municipal bond yield is equal to a 7.69% yield on a taxable bond. For an investor in the 28% tax bracket, the tax-equivalent yield would be 6.94%. (Tax-equivalent yields do not reflect state and local income taxes or the alternative minimum tax [AMT], if any, and will vary based on an investor's tax bracket.)

3. Investors were tuned in to the yield ratio.
The ratios of the yields on municipal bonds to the yields on Treasury securities are closely watched by many investors. Prior to the 2008–09 credit crisis, these ratios never really touched 100%, but since that time, it has become very common. When ratios of munis to Treasuries, especially those with 10-year and 30-year maturities, have moved significantly above 100%, there has often been increased demand from crossover buyers—that is, those who also invest in markets other than munis—and hedge funds. (Ratios are based on data from Municipal Market Data [municipal bond rate] and Bloomberg [Treasury rate].) The ratios had hovered around 100% without much demand during April and May 2013, but after they reached about 105% during the second week of June, demand increased. Similar to the yield-focused buyers mentioned above, investors who watched relative value were willing to step up to the plate when the time was right.

4. Retail investors shot first and asked questions later.
In this most recent market downturn, without having evidence of material economic changes or significant developments specific to the asset class, retail muni investors chose to sell anyway. Much of the recent market decline could be attributed to selling from the retail segment, as institutional buyers appeared to keep their powder dry.

While this is typical behavior, compared with historical patterns, this time retail investors have been selling based upon interest-rate forecasts faster, and this has caused market prices to adjust down to clearing levels faster. In 2008 and 2010–11, selling occurred over many more weeks before prices rebounded—but at lower amounts of redemptions per week.

A key point about this recent downturn is that the credit fundamentals of the municipal bond market have not changed for the worse—in fact, they are continuing to improve. State tax revenues keep increasing every quarter and local tax revenues are seeing an upturn, according to data from the Census Bureau. Investment-grade municipal bond defaults remain virtually nonexistent, according to data from Moody's. While there are some defaults in the high-yield market, the pace of those defaults is declining.

As the redemptions have slowed, the market has started improving, allowing bond prices to start increasing again. So, depending upon timing of their sales, many muni investors might have done better staying invested, allowing them to participate in the market rebound.

5. Amid the tumult, issuers still were willing to enter the market.
Even in turbulent markets, at adjusted prices many municipal bond issuers were able to issue tax-exempt bonds and raise the capital they needed. Many issuers brought forth new bond issues during June, including the New York State Environmental Facilities Corp., the Massachusetts School Building Authority, and the Riverside County [California] Transportation Commission. Some deals were postponed or downsized, but issuers who had to come to the market were able to do so.

The State of Illinois is an example of an issuer with a negative outlook from major credit rating agencies—and well-documented headline issues—that was still able to raise more than $1 billion in a new offering on June 26, 2013. It may not have been an ideal time to come to market, and many issuers chose to postpone their offerings, but there was a market for those who vitally needed to raise capital.

Summing Up
What did the recent muni market sell-off teach us? Well, market activity is dominated by retail investor demand, either through funds or individual bonds. Also, there are a range of buyers available in times when liquidity is challenging, and even though there can be significant costs, the market is quite liquid. Buyers are willing to recognize value when it emerges. And even in periods of volatility, most issuers can bring forth new offerings as long as they are priced properly and adjusted to market conditions.

While it is too soon to call a bottom, because investor demand is still uncertain going forward, it appears that this episode, like other trying times in recent years, has allowed the muni market to demonstrate impressive resiliency and viability.

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