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(Second of two parts. Read Part I here.)
In Part I of this article, we examined the state of the muni market after a tumultuous 2013. Now it's time to look ahead. With the current year nearly wrapped up, which trends should muni investors be watching in 2014—and what factors could help the market continue its recovery?
What to Watch
The Fed—While the Federal Reserve is hinting at tapering its $85 billion in monthly bond purchases, it is not expected to raise the fed funds rate for a while, so yields on short-dated muni bonds are not likely to move higher for a while. This suggests support for the low historical volatility of short-duration funds.
Supply—New-issue supply should stay on the lighter side for a while as higher interest rates continue to cause refunding deals for outstanding bonds to be out of the money and while issuers continue to be reluctant to borrow unless they need to do so. Last year's high level of new-issue supply was due to more than half the new issues being used to refund outstanding bonds.
Puerto Rico—Puerto Rico has made it clear that it does not need to access the bond market for a new issue through the end of the commonwealth's fiscal year, which is next June 30, but officials would like to sell bonds if they can. The credit ratings agencies would also like to see Puerto Rico prove its market access by issuing bonds soon. When the government does try a new issue, it will most likely be with its sales tax-backed bonds from the Puerto Rico Sales Tax Financing Corp. (COFINA), which would allow it to borrow at lower rates than if it used general obligation bonds. We expect Puerto Rico to try issuing these bonds during the first quarter of 2014 as the commonwealth continues its efforts to improve the fiscal situation. So far, Puerto Rico's revenues have come in ahead of last year's numbers and budget projections, but this trend will need to be followed closely to see if it will continue.
Tax policy—Discussions of tax reform in Washington may again include proposals to limit munis' tax-advantaged status since this idea has been repeatedly included in discussions in recent years, but the probability of this type of change occurring is low. With the struggles for consensus in Washington, this does not appear to be one of the issues at the forefront of the debate. Still, lack of closure on this item is not a positive for the market nor are other ideas being passed around Washington regarding changing the classification of municipal bonds in bank portfolios.
It is important to remember that any issue that puts pressure on the municipal bond market and leads to higher interest rates will also cause the borrowing costs for municipal governments to rise. In order to cover the higher interest expense within their budgets, municipal governments need to either 1) pare spending on various items, including essential services, or 2) increase taxes or user fees to offset the higher borrowing costs. The borrowing is for specific purposes and does not disappear just because interest rates rise, so eventually the increased borrowing costs caused by proposals in Washington or media headlines will have to be passed on to anyone paying taxes or using services of the government.
Some Favorable Signals
As a result of the market action of 2013, and despite the continued fund outflows, munis should actually now be more attractive to retail investors for the following reasons:
1) According to Municipal Market Data (MMD), as of November 30, 2013, muni yields were more than 100 basis points higher than a year earlier when there were solid fund inflows.
2) Tax rates are higher than a year ago, leading to higher tax-equivalent yields.
3) The ratio of yields on longer-dated municipal bonds to yields on Treasuries of comparable maturity is still more than 100%, according to MMD.
4) The market has had three months of positive returns, so there has been stability despite the constant pressure from media headlines.
At some point, these trends should lure individual investors back into the fold. Although the municipal market may not perform in a similar manner under similar conditions in the future, in reviewing history, it is rare for municipals to have negative total returns for a full year, as we will most likely have in 2013, and, historically, they have bounced back quickly after down years, as illustrated by market rebounds in 1995, 2009, and 2011, for example.
Points to Remember
In recent years, there has been a significant effort by the Securities and Exchange Commission and the Municipal Securities Rulemaking Board to improve disclosure of financial information by issuers and trade information by dealers. While there is clearly more that needs to be done, the result so far is a better functioning, more transparent market. Institutional and individual investors have access to a wide range of information—as long as they know where to search for it. Much more is desired by investors and needed by the market, but it is a significant improvement over where things stood 15 years ago or even five years ago. Despite the lack of disclosure at those times, the market functioned sufficiently for municipal governments and related entities to finance their capital projects and general financial needs.
With the recent negative press about the municipal bond market, it has often been forgotten that the primary function of munis is to finance projects or services that are essential to the well-being of the general population. Issuers' ability to borrow in this market benefits not only the individuals and institutions that purchase these generally tax-exempt instruments but also, ultimately, individuals at every rung of the socioeconomic ladder.
With the market on track to handle more than $300 billion of bond issuance this year (based on projections from SIFMA data), despite the negative sentiment, and with the rally off its lows over the past few months, the market is functioning well, while providing attractive tax-exempt income and continuing its historical record of consistent long-term performance to its investors.
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. 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. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
A general obligation bond typically refers to a bond issued by a state or local government that is payable from general funds of the issuer, although the precise source and priority of payment for general obligation bonds may vary considerably from issuer to issuer depending on applicable state or local law. Most general obligation bonds are said to entail the full faith and credit (and in many cases the taxing power) of the issuer, depending on applicable state or local law. General obligation bonds issued by local units of government often are payable from (and in some cases solely from) the issuer's ad valorem taxes, while general obligation bonds issued by states often are payable from appropriations made by the state legislature.
Taxable equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. It does not reflect state and local income taxes of the alternative minimum tax (AMT), if any, and will vary based on an investor's tax bracket
One basis point equals 0.01%.
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.