Municipal Commentary – November 2012
Municipal Bonds – Picking up Nickels in Front of a Train!
• Municipal Bonds Attractive Relative to US Treasury Notes
• Yield to maturity at Multi-decade Lows
• Credit spreads continue rallying on moderate economic growth
• Recommend reducing interest rate risk and maintaining single A average portfolio
In 2012, longer maturity Municipal bonds preformed well as yield curves flattened – driven by a reach for income fostered by the Federal Reserve’s printing press. The yield to maturity for 5 and 10 year AAA rated municipal bonds fell 23 and 37bps, respectively, for the year through mid November, matching the move in UST notes. The 30 year sector of the municipal market radically outperformed US Treasury Notes with the yield to maturity falling 100bps compared to the 19bps decline in 30 year US Treasuries.
According to data compiled by Bloomberg, new issue supply in the municipal market, increased about 40% compared to 2011. The market appears to be on pace for approximately $340 million in supply or slightly above 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. An improvement in credit quality, the low level of interest rates, an up-tick in new issuance, and an irresponsible Federal Reserve resulted in a slight cheapening of the municipal asset class to US Treasury Notes. Substantial improvement in long end ratios did occur as investors moved out the curve, driving long term yields lower while keeping shorter interest rates relatively stable.
In the last few weeks, we have witnessed a respectible amount of inflow into municipal bond funds – and the beginning of a corresponding richening of municipal bonds relative to US Treasury Notes. Much of that demand can be attributed to a few catalysts – a prospect for higher taxes, low absolute yields in US Treasury and Corporate paper, and a money printing Federal Reserve. As new issuance wanes in the wind down to year end, we think the municipal market could continue to improve relative to UST notes. For instance, we saw 10 year AAA rated Municipal bond ratios in excess of 120% of US Treasury Notes during the second quarter as US Treasuries began pricing in mid-year slow down. Although municipal bonds are cheap to US Treasury Notes, the yield to maturity is 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 less highly 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 – although more selectivity needs to be applied as spreads have rallied nicely. The opportunity still exists in credit, but less so.
We recommend that investors lessen their sensitivity to interest rates. An investor can lessen his interest sensitivity 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.
In general, State and Local governments have been working steadfastly to improve fiscal budgets. Economic activity has increased slowly over the past few years, which has lead to improving revenues.
Although improvements have been realized, spreads remain elevated – presenting an opportunity to pick up income without increasing interest rate risk.
Two caveats: If the US Congress again self inflicts Americans to an underwhelming show of integrity, and lands us over the fiscal cliff, the pace of improvement in the domestic economy may decline. A decline in economic activity will suppress the recent uptick in tax revenues creating pressure for many credits. In addition to the slowdown in tax revenue, direct federal outlays to states and ultimately local credits may also be curtailed, adding to the revenue shortfall. Many state and local governments with high fixed costs, underfunded pensions and infrastructure improvements will again find themselves in the red. Couple this with the GASB change to the reporting of the unfunded pensions liability onto the balance sheet and we may see the positive effect of higher taxes on municipal bonds fail to offset the widening in credit spread premium.
The second caveat is that despite the possibility that marginal tax rates may rise, the current administration may chose to reduce the tax benefit of municipal bonds by limiting their deduction.