Municipal Bonds – Value in a Risky Interest Rate Environment!
• Municipal Bonds Attractive Relative to US Treasury Notes – Again
• Increase in yield to maturity a welcome development….But the rate is still low!
• Targeting AA rated paper as investors sold good bonds into a bad market
• Implementing interest rate hedges to offset higher rates
Many investors are smarting from shockingly negative returns in bond funds, including ETFs and closed end funds. Thus far, in 2013, longer maturity Municipal bonds under –performed a dismal US Treasury market. Municipals have been in excess of 100% of UST Treasury Notes for most of the year, as tax concerns and the absolute low level of interest rates curtail demand. Fed Chairman Bernanke’s remarks in June, fostering the first hints of removing excess monetary stimulus, left the highly overbought fixed income market in disarray. The yield to maturity for 5 and 10 year AAA rated municipal bonds rose 46 and 97bps, respectively, for the year through July, – with the 10 yr more than out pacing the rise in UST notes of 84bps. The 30 year sector of the municipal market radically under-performed US Treasury Notes with the yield to maturity rising 138bps compared to the 71bps rise in 30 year US Treasuries.
For example, the Barclay’s Municipal Bond Index has declined 3.9% in the last six months, pulled down by the 8% decline in the long portion of the index (22+ yrs). This compares to a drawdown of 1.6% for the Barclay’s Aggregate and 6.3% decline in long maturity government bonds as measured by the Barclay’s Long Government Index.
Although the rate rise was sharp, it is reasonable to believe that this was just the beginning of the correction to more normalized interest rates. However, we think that this period of under-performance provides a short term opportunity to pick up relative value, however, we are uncomfortable being long only and prefer to extend into municipals in a hedged portfolio.
According to data compiled by Bloomberg, new issue supply in the municipal market, has fallen to about 90% of last year’s pace. The market appears to be on a track for approximately $320 billion in supply or slightly below average for the past five years. Credit quality, measured by the total amount of state revenues collected showed strength – leading to improvement in the budget positions of many municipal entities. “Belt tightening” and longer term fiscal planning are easing expenditure pressure.
In the last two months, we have witnessed a sizable amount of redemptions of municipal bond funds – and the corresponding cheapening of municipal bonds relative to US Treasury Notes. Much of that selling can be attributed to a few catalysts – a question of long term tax changes, low absolute yields in US Treasury and Corporate paper, and the beginning of the wind-down of the Fed’s US Dollar printing i.e. – tapering QE. As new issuance continues to wane in the near term summer season, we think the municipal market may improve relative to UST notes. Although municipal bonds are cheap to US Treasury Notes, the yield to maturity is still, despite the recent rise, at multi-decade lows – resulting in a risk reward payoff that is skewed to the downside.
In our opinion, the Federal Reserve is encouraging investors to increase risk to enhance income. This can be accomplished in several ways including extending maturity and shifting down into lower rated credit. We view the risk reward trade off as favoring an investment in a portfolio of single A rated average credit versus the more typical AAA or AA rated average portfolio. The credit risk premium for single A and BBB rated credits is still attractive.
We recommend that investors lessen their sensitivity to interest rates by shortening the average maturity of the portfolio or by implementing a portfolio of interest rate hedges. Interest rate hedges are positions that increase in value as interest rates rise, thus offsetting the mark-to-market loss suffered on a long only portfolio. Also we recommend that investors review the vehicle they utilize to access the bond market. After the wild ride that ETFs experienced relative to the underlying market, we continue to recommend portfolios of individual bonds.