INSIGHTS

On April 23, 2013

Municipal Bonds Run the Gauntlet and Emerge Intact

Municipal bond investors are entitled to take a breath and regroup. The past four months have presented a series of deadlines and seasonal challenges that had the potential to heighten overall market uncertainty and negatively impact municipal bond values. A litany of do-or-die dates tied to the fiscal cliff, the debt ceiling, sequestration, and the continuing budget resolution have come and gone. None were resolved with any sort of grand bargain (or even small bargain) that would have capped or eliminated the exemption on municipal bond interest. It is easy to forget, now that we appear to be in the clear for time being on the exemption, that there were a number of occasions in the past four months when the prospect of changing the municipal tax exemption seemed more than remotely possible. The effects of these concerns, the usual March pattern of rising Treasury bond yields, and expected selling pressure from April 15 tax payments all presented a gauntlet of sorts that municipal bond investors needed to get through. 

The municipal bond market has emerged from this recent challenging period in reasonably good shape. It has been helped along by a flight to quality rally in Treasury bonds caused by the Cyprus banking sector crisis. A weaker than expected payroll employment report has also helped to push Treasury bond yields lower. Municipal bond yields have followed the direction of Treasury yields but not to the same degree. Good quality, double A and single A rated municipal bonds can still be purchased with yields comfortably above Treasury yields even before taxes are considered. It is undeniable that interest rates currently remain at low levels compared to years past, but municipal bonds still provide attractive after-tax yields given conservative alternatives available. This simple observation is important to remember in a world of zero percent Fed Funds rate, near zero percent return on cash, and very low Treasury bond yields. 

Another factor creating a relatively benign environment for municipal bonds is the currently positive supply/demand dynamic. The level of new issue supply so far this year has not overwhelmed the market. The continued steady demand for municipal bonds from investors has easily digested new deal volume and these supply/demand fundamentals are likely to continue in the near future. The May/June/July period in the municipal bond market traditionally has been one of relatively high reinvestment and robust demand. 

Having emerged relatively unscathed from the recent gauntlet and with favorable supply/demand fundamentals going forward, will it be smooth sailing for the municipal bond market for the rest of the year? 

There are a number of developments that could rough up the relatively smooth seas now facing the municipal bond market. Positive surprises in the labor market and in the growth rate of Gross Domestic Product could heighten the level of anxiety about rising interest rates. In addition, we have seen rates pop up a bit when speculation increases on how long the Federal Reserve can (and should) maintain its securities purchasing program. An extended period of steadily rising stock prices could prompt a meaningful shift in allocations from bonds to stocks. The Stockton California bankruptcy case will also be closely watched to see if a haircut for municipal bond holders will be part of the city’s plan for stabilization and renewal. The possibility of changes to the municipal bond tax exemption remains although we now judge it is less likely that any agreement to transform the exemption will come to fruition this year.

In an earlier blog posted in January of this year (Crosscurrents and Contradictions),we outlined two broad scenarios for the municipal bond market: a fairly benign Scenario 1 and a more challenging Scenario 2. We presented those two perspectives as a useful way to gauge which way the municipal bond market might be leaning at any given point. We recognize presently that the municipal bond market has a number of potentially disruptive forces lying in wait. We don’t dismiss them, but we do believe the scales are tipped more in the direction of a relatively benign Scenario 1 for the next three to five months. A recap of how we described Scenario 1 will present a fair picture of what we now believe are the primary forces at work in the municipal bond market:

“Higher tax rates continue to fuel the strong demand for municipal bonds. The exemption on municipal bond interest is left alone. The supply of new issue municipal bonds is somewhat higher than in 2012 but not enough to cause indigestion in the market. The economy and the labor market continue their gradual recovery with no growth surprises to the upside.  The Fed shows no sign of modifying its accommodative stance. Any rise in Treasury bond yields is fairly muted.”

As we exercise our current judgment, we also know that markets can surprise and confound us. We remain vigilant and urge investors to be prepared with an understanding of the credit quality, duration, and potential volatility risk in their portfolios. Of course, we cannot say with certainty what is in store for the municipal bond market, but we believe one of the takeaways outlined in our earlier January post still holds for today’s market:

“Our nation’s infrastructure needs will remain large, municipal entities will need to finance long-term projects for the benefit of their communities, and the asset class called municipal bonds (tax-exempt or taxable) will continue to exhibit characteristics desired by investors. These characteristics include an enviable record of safety and resiliency, comparatively modest volatility, tremendous variety to help investors with diversification, and attractive yields among conservative investment choices.”

April 22, 2013

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. For additional risk information see the Blog and Commentary Disclosures website. For additional commentary or financial resources, please visit www.aamlive.com