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(First of two parts.)
To say that the municipal bond market has had an eventful 2013 would be an understatement. The market was hit by a significant sell-off that began in May amid speculation that the Federal Reserve would begin to dial back on its quantitative easing program, which sparked a rise in interest rates across most fixed-income markets.
Further, the muni market subsequently faced negative headlines from the Detroit bankruptcy in July and concerns about Puerto Rico's fiscal health in August. The Puerto Rico concerns reached a crescendo with the publication of a Barron's article that spotlighted the commonwealth's fiscal, economic, and muni market challenges, along with identifying some mutual funds that have high concentrations in their bonds. All this information had been well known and documented for some time, but it still managed to surprise some investors, leading to more market pressure.
While the outflows are continuing, the pace is much slower and the market is performing much better. In fact, total returns, as measured by the Barclays Municipal Bond Index, have been positive from September 1 through November 30—even though the market has experienced 27 consecutive weeks of outflows from municipal bond funds through November 30, according to Lipper data. This might come as a surprise to people who are only following the headlines and not market performance.
Many of the factors that turned 2013 into a challenging year in muni-land appear to be largely stabilizing. With a new year rapidly approaching, we thought this would be a good time to assess the current state of the muni market. We'll do that here in the first of a two-part article. In Part 2, we'll look ahead to the factors that may influence the market in 2014.
Despite the various bumps and bruises of 2013, the muni market is functioning well. With data from Thomson Reuters showing recent market activity of approximately $5 billion a week in new bond issues—including a high of more than $8 billion during the third week of November—and $700–900 million in weekly mutual fund outflows, there still has been plenty of demand available to allow all the new deals to get done. In fact, a number of significant new deals have been completed in recent weeks, including a closely watched $1.8 billion offering from Jefferson County, Alabama, to end its bankruptcy, and financings of $1.5 billion each from the Port Authority of New York and New Jersey and the State of California.
While retail investors have been pulling money out of mutual funds, there has been strong demand from investors often referred to as crossover buyers—institutional investors who do not typically participate in the muni market. These investors are able to invest in all fixed-income markets, but are selecting munis due to their current attractive relative value. Demand from crossover buyers helped put a floor under muni bond prices in the summer and has since added to the momentum leading to the market rally.
Another demand-side feature that has added to market pressure has been retail investors selling in order to recognize tax losses. Since most municipal bonds are down in price for the year, some investors have been selling their fund shares or bonds to recognize their losses and then use those losses to offset gains in other markets. As we reach year-end, that selling pressure should lessen, along with its negative influence on market demand.
Market and Credit Signals
The yield curve, which is the difference in yield between one-year bonds and 30-year bonds, remained very steep compared with historical levels as of November 30, according to Municipal Market Data, creating a situation wherein there is a potentially substantial yield and total return advantage to extending maturities. The yield curve was steep at the start of 2013, but has become even more so as long-maturity muni issues have underperformed. The majority of this change was caused by demand from risk-averse investors, who favored bonds with maturities of five years or shorter over longer-dated bonds as interest rates were rising. With prospects for an improving economy and a shift toward tighter policy by the Fed, the yield curve will likely flatten. The big, unanswerable question, of course, is when this will happen.
Credit spreads—that is, the incremental yield difference between lower-rated bonds and their higher-rated counterparts—have widened this year as lower-quality bonds have underperformed, as measured by the performance of the Barclays Municipal Bond Index versus the Barclays High Yield Municipal Bond Index. Although credit quality did not become worse, perception of market credit quality has become lower and demand for lower-rated bonds decreased, leading to their underperformance. This has increased the yield advantage for taking on credit risk and provides the potential for higher returns in an environment where the economy is improving, which could lead to tighter spreads.
According to research from Morgan Stanley, credit-quality trends remain generally favorable despite the media headlines. Data from the U.S. Census Bureau show that state tax revenues have increased every quarter for the past three years, while local governments are experiencing better economic conditions on the whole. While it is difficult to quantify an exact number with municipal bond defaults, there are still very few occurring, and the history of extremely low default rates for investment-grade municipal bonds is continuing.
While there have been some downgrades of muni issues by Moody's Investor Service, most of the changes have been small changes, moving one notch, such as 'Aa2' to 'Aa3,' and this has had very little market impact. It should be noted that many such moves have been caused by some not surprising readjustments as individual credits are being reviewed now after Moody's raised the ratings of entire muni-market sectors after changing muni ratings to a corporate equivalent scale a couple years ago.
Some Final Thoughts on 2013
While 2013 has been challenging, many of the difficulties for the market have been caused more by changes in investor perception rather than material alterations in overall municipal bond credit quality. The market continues to see substantial trading volume, suggesting that there has been liquidity and that many issuers continue to access the market for successful bond financings.
Based on Bloomberg data as of November 30, total returns for the year are negative for most municipal bonds with maturities longer than five years, but longer-term total returns are still positive for this category and tax-exempt income remains attractive. [Of course, market conditions could change at any time and there is no guarantee that the municipal market will perform in a similar manner in the future.]
Part II of this article, "What's in Store for 2014?" will examine the factors that could influence the municipal bond market in the coming year.
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.
The Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is a broad measure of the municipal bond market with maturities of at least one year. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, Standard & Poor's, and Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. Bonds must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.
The Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds. The Barclays High Yield Municipal Bond Index is a subset of the Barclays Municipal Bond Index; a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.