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After a rewarding year for many municipal bond investors in 2012, there is some uncertainty about what 2013 may have in store. Some perspective on relative value trends, recent market developments, and particular issues that might affect the asset class could help investors identify this year’s potential investment opportunities.
1) Proper Perspective for Relative Value
The capital markets have been in an unprecedented environment during the economic recovery, and investors evaluating the market in the context of only the past five years could overlook further opportunities. For example, one of the most visible signs of the Federal Reserve’s policy accommodation has been the steepness of the yield curve—that is, the yields on bonds with similar quality ratings but different maturities—relative to its historical levels. That suggests that investors still can find potential value in longer maturities.
Despite last year’s significant outperformance of the longer-term portion of the market, the municipal yield curve still stood at about 280 basis points (bps) to start 2013. That’s 10 bps steeper than the long-term average,1 but it appears even steeper when considering that it was less than 50 bps in early 2007, before the Fed started its aggressive policy accommodation. The portion of the curve consisting of 10- to 30-year maturities is even steeper compared with historical averages.
Similarly, the extreme market dislocation of 2008 left credit spreads between high-rated and lower-grade bonds extraordinarily wide. That creates opportunity for investors who are willing to assume a little more credit risk potentially to find yields well above average at the lower end of the rating spectrum.
Even after tightening last year, the yield spread of ‘BBB’ rated muni bonds to the yields on ‘AAA’ rated muni bonds was 220 bps at the end of 2012, 96 bps wider than the long term average.2 Also, the spread of high-yield (below-investment grade) muni bonds over investment-grade munis was 350 bps at the end of last year, 73 bps wider than the long-term average.3
2) Watch for Headlines
The outcome of Washington’s ongoing fiscal drama has broad implications, and the municipal bond market continues to be directly affected. While the recent tax package could be considered largely positive for the municipal bond market, there are other fiscal issues that will require negotiation and may not have a similar outcome.
Indeed, if one now views the “fiscal cliff” as consisting of two parts—the first regarding revenues and the other regarding spending—then it was very positive that the recent tax package did not include a previously suggested 28% cap on the exemption for municipal bond income. Given the unpredictability of Washington, however, this is an issue that could resurface, and new headlines about an exemption cap could negatively affect the municipal market.
Investors also should expect additional headlines about underfunded pensions and municipal bankruptcies. While both issues are serious, they deserve some context. To start, most states are considered to be sufficiently funded, but the news reports will often focus on the handful that are not. Also, the worst pension issues, such as those in Illinois, are not current issues for the market. In most cases, it will be years before the liabilities will need to be paid out. Delays in dealing with pension issues, however, could contribute to credit-rating downgrades.
Another municipal bankruptcy would generate headlines, but it is important to recognize the rarity of Chapter 9 filings. Professional credit research could assist investors in avoiding not only those municipalities that are bankruptcy risks but also those that are facing consistent economic deterioration.
3) Tangential Factors in Play
The Fed is expected to continue its quantitative-easing initiatives through the first half of 2013, at the very least, keeping both short and long-term rates near their historically low levels.
But if the pace of growth were to accelerate, this could prompt the Fed to curtail some of its asset purchases, and, consequently, long-term rates could move higher. This scenario could potentially benefit the more credit-sensitive segments of the municipal market because a strengthening economy should improve overall credit quality and, consequently, tighten credit spreads.
Another issue that could affect certain segments of the municipal bond market is the implementation of the Patient Protection and Affordable Care Act, which is scheduled to be in place by January 2014. There are some widespread uncertainties about how the various components of the act will be implemented, which could affect the healthcare/hospital portion of the municipal bond market. Still, hospitals have been given a lot of lead time to prepare for these changes, so most of them should be well positioned for the act’s eventual implementation.
4) Reading the Tea Leaves
The combined prospects for headline events that are specific to the muni market and the broader factors that can affect all the capital markets support some expectations we have for the muni market in 2013, including:
• Assuming that the Fed’s policy efforts to keep interest rates range-bound are successful, total returns on municipal bond investments should approximate their current yields, and could be slightly higher, since there are opportunities for positive price performance from relative-value opportunities.
• The large volume of refinancing-related issuance in 2012 underscores the risk that individual investors are facing when their bonds are being called away, thus leaving them with the challenging task of reinvesting the returned principal in the current low-rate environment. This issuance trend is likely to continue, therefore leading to negative or limited changes in the net supply of outstanding municipal bonds.4
• As long as interest-rate volatility remains subdued, which is likely given the Fed’s policy initiatives, municipal bond demand should be strongly positive. More than $50 billion flowed into the asset class in 2012.5
• If economic growth continues at its current pace or better, credit quality across the country should remain consistent with its historical stability. This would continue the trend from 2012, when the municipal bond market saw its fewest number of defaults in three years.6
5) Areas of Potential Opportunity in 2013
Municipal bond opportunities in 2013 could begin with the overall asset class itself for tax-sensitive investors. After all, the recently passed tax package (the American Taxpayer Relief Act of 2012) phases out some exemptions and limits deductions. For many investors, these adjustments may underscore municipal securities as one of the remaining viable tax havens. Some specific areas of opportunity within the market in 2013 could include:
• Investment-grade bonds with credit ratings below ‘AA.’ Credit spreads are still wide compared with historical averages, and credit quality appears to be improving with the economy. The long-term portion of the market, particularly bonds with maturities of 21–25 years, could continue to outperform, but with potentially more volatility. [There is no guarantee, however, that the market will perform in the same manner under similar conditions in the future.]
• Bonds with 10-year maturities are an attractive segment of the curve, especially when considering the potential for total return versus interest-rate risk.
• If home sales continue to accelerate, some municipal bond sectors that are backed by revenues from increasing real-estate values, or that benefit from a housing market recovery, could appreciate. This includes tax-revenue bonds where the taxes come directly from real estate, or other projects that benefit from the increased ability of consumers to sell their homes.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
A basis point is one one-hundredth of a percentage point.
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. Investments in high-yield securities sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Lower-rated investments may be subject to greater price volatility than higher-rated investments. Income from municipal securities may be subject to the alternative minimum tax. 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. No investing strategy can overcome all market volatility or guarantee future results.
The credit quality of the securities in a portfolio is 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.