INSIGHTS

On November 05, 2013

Despite Headlines, There are Opportunities in Quality Municipal Markets

As consternation increases with each passing day with regard to interest rates, market tops, Washington, D.C. “Soap Operas” and the Federal Reserve, the one constant over the last several years has been the search for yield with appropriate risk. As evidenced by this year, duration and its vulnerability to interest rate shocks reared its head in the summer. With the U.S. 10-Year Treasury going from 1.80% to 3.00% over the last six months, many are paralyzed by the 2.60% yield at the current level.

One area that has suffered the most is the municipal market arena. We have seen the “Detroit Syndrome” permeate all aspects of credits with the most recent being the Puerto Rico dilemma. When removing headline risk and trading abnormalities over the last few months, we are left with an opportunity in several quality municipal markets.

For only the seventh time since 1983, we saw a 12-month total return for the Barclay’s Municipal Index turn negative recently.

Extrapolating what occurs after this event, one has seen a significant rebound in the two years following the first crossing of the negative 12-month return threshold. Consider:

If we remove the two outliers (removing 48.64% and 10.06%), the total return average for the following two years turns out to be 18.65%.

One could – and should – argue that this timeframe is only during a secular bull market and may not coincide with the current situation where we have such low rates and a potential secular bear market may be at hand. That is a valid point and therefore mitigates some of the magnitude of the averages; however, we also must consider that the relative bench mark is at such anemic levels, that a return of the worst two-year scenario (10.06% as evidenced by May 2004), may actually be an outperformance of similar natures in the past.

Another perspective is the percentage of Treasuries that is also a bit overstated considering the low level of the 10-Year Treasury.

 *Past performance is no guarantee of future results.

As evidenced above, municipals (muni) are trading at well above the median percentage of Treasuries. Though we agree it is being exacerbated by the low level of Treasuries, to explain this difference one must consider two scenarios:

1. Will the price of municipals go up to a more normal level, therefore offering total return potential, or
2. Are Treasuries going to move up in yield to offset the current wide spread?

Though we conservatively would agree with the latter, there is a case to be made that it will be a combination of both scenarios. Whether you argue for a total return potential or a hedge against higher rates, considering the low relative benchmark that is the current and potentially short-term scenario for a traditionally secure instrument, municipals seem to be temporary oasis in the desert of yield.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.