INSIGHTS

On February 24, 2014

Viewpoints from AAM - The Case for a Strong 2014 Municipal Market

While I understand interest rates are at historic lows and there isn’t room for them to go much lower, a strong case can be made for the municipal bond market to provide a positive return in 2014. A combination of higher tax rates, volatile equity markets, a fragile U.S. and world economy, and short-term interest rates that should hover around 0% until at least 2016, could add to a positive year for municipals. The increase of fear in the municipal market due to Puerto Rico and Detroit – which added to the historic outflows of 2013 and the relative cheapening of Municipal yields – could also reverse and add to the positive return for 2014.

Tax bills will be higher for many Americans in 2014 and the typical municipal investor who contributed to the historic outflows of 2013 could decide that it is safe to re-enter the market to defray some of that tax bill. This potential change in attitude could lead to large inflows and stronger demand in a year in which issuance is expected to drop to approximately $280 billion from $330 billion; add in all the bonds due to mature and refunds expected in 2014, and a strong case can be made for a year of negative net issuance.

The S&P 500 returned approximately 30% in 2013 and while it could repeat that performance in 2014, investors have become skittish due to volatility in the last two decades. The strong returns of 2013 could lead investors to search for less volatile alternatives and the relative cheapness of municipals could add to the demand I expect in 2014.

The term “don’t fight the Fed” has never been as valid as it has been the last few years for participants in the financial markets. The Federal Reserve has provided an extraordinary amount of stimulus to the economy, which has resulted in strong returns for all financial assets. While I believe that the Fed would like to slow the flow of stimulus by reducing its asset purchase program, it should to be done at a snail’s pace. In May 2013, the first time the Fed mentioned it was going to taper its asset purchase program the 10-year Treasury spiked to 3%, which in turn lead to an immediate slowdown in economic activity. This economic slowdown happened again as the 10-Year Treasury approached 3% again at the end of the 2013. It would seem that 3% is a temporary ceiling that the Federal Reserve should consider as they ponder their next steps. The Fed has also maintained a 0% interest rate policy that added to the massive amount of stimulus and, because of the fragility of the economic recovery, I believe that the 0% policy will be maintained well into 2016.

We believe “don’t fight the Fed” will be a wise mantra for 2014 because any reduction of stimulus could be meaningless relative to what the Fed is currently doing; the only difference would be the volatility associated with the headline risks. The Fed will likely maintain the majority of its stimulus which should keep interest rates at historically low levels. The low interest rate environment could also lead investors to search for relatively cheap assets that could be less volatile.

Last but not least, there is a chance that the liquidity issues Puerto Rico faced in 2013 will be addressed by a bond offering in 2014. If successful, a bond offering could lead to spread tightening not only in Puerto Rico credits but all other high yield credits and possibly credits carrying ratings as high as A. A significant factor in this tightening of spreads could be the realization that even with all the fear-inducing headlines of 2013 regarding municipal defaults, the actual number of defaults was lower than 2012.

Finally, it has been my experience that anytime there is excessive fear in the municipal market – like we experienced in 2013, which led to negative returns and significant relative cheapening – the following year has historically been a good one.

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 Municipal Disclosures webpage. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com