We have witnessed a truly amazing (and shocking) period in American financial history, over the past year-and-a-half. From the mortgage meltdown, to the Lehman Brothers failure, to the stock market crash, and the resulting run on the money market funds and fixed income markets, we have seen unprecedented disruptions in capital markets here and abroad.
For fixed income investors normally accustomed to stability of principal in their portfolios, these recent gyrations have resulted in a massive loss of confidence (and a lot of money). However, we have seen a sizable rebound in municipal bond prices in recent months, drawing investors back to the market, and lowering available yields on muni bonds. So, the question is: Are there still opportunities in the muni market?
In this week’s column, I will address some of the possible risks in the California municipal bond market, and discuss some of the reasons why now might be a good time to seriously consider these investments.
First, a little history… when the financial markets imploded in late 2008, major financial institutions, hedge funds, and other large institutional investors were forced to liquidate sizable chunks of their muni bond portfolios. The major banks, due to the mortgage market, incurred huge losses as their mortgage-backed securities plummeted, their ability to make new loans was compromised, and their stock prices dropped to a fraction of their pre-implosion values. Hedge funds, which rely on a high degree of leverage—borrowed money—to fund their trading operations, were forced to sell munis to cover margin calls, as their stock, mortgage-backed securities, and derivatives positions lost value. Other institutions, many of which are required to hold only AAA-rated munis, were forced to liquidate their muni positions as the ratings agencies scrambles to reassess risks in the muni market, and as they reduced the ratings for many municipalities to below AAA.
The combination of all of this selling from such a huge segment of the muni market that were normally big buyers of munis, had a devastating impact on muni prices, driving yields up to unprecedented levels. In hindsight, this was a huge buying opportunity, and as stated above, muni prices, as with the prices of corporate bonds, have rebounded sharply in recent months, bringing yields back down somewhat.
Where are we now?
So, to address the question above: (Are there still opportunities in the muni market?), we need to understand the muni yield curve and its relationship to the treasury yield curve. Historically speaking, munis tend to have a negative spread to treasuries. This simply means that if you compare a muni bond to a treasury of the same maturity, you would typically see a lower percentage yield on that muni compared to the treasury. For example, if a 5-year treasury was yielding 5%, a 5-year AAA-rated muni would typically have a yield of about 4%. Today, this is not what we see… top-quality munis are still yielding more than equivalent maturity treasuries.
The treasury curve is very low overall, in terms of yields, and is very steep, meaning that longer maturities are much higher in yield than shorter maturities. Also, because overall yields are historically very low, the percentage difference between long and short maturities is really, really large.
What we would expect to see is that the AAA-rated California muni yield curve would closely mimic the treasury curve, but would be slightly below it, by about 100 basis points (1%). This is not what we see! In fact, it is the exact opposite—the Cal muni curve is above the treasury curve!
(Municipal bonds are state and federal tax-free for residents of the state of issuance. Due to this tax benefit, states can issue their bonds at lower interest rates, saving the states money. Investors are willing to accept the lower rates (as compared to equivalent taxable bonds) because they get this tax advantage on their interest earned. Of course, if you are a muni bond investor you already know this.)
Implications
As mentioned above, demand for munis has begun to rise, and prices have rebounded as a result. However, judging by the current yield curve comparison above, I would expect the muni bond market, in general, to perform well going forward, as the relationship between muni yields and treasury yields moves back to its normal level—muni yields below treasury yields by about 100 basis points. If this occurs, the implication would be that munis will perform much better than treasuries going forward.
The recent introduction of BABs—Build America Bonds, issued by state and local governments with the proceeds intended for stimulus-related projects—has lessened the supply of new munis. These bonds are taxable, but 35% of the interest expense incurred by the municipality is reimbursed by the federal government, so the net cost to the municipality is substantially reduced, allowing them to pay higher rates and attract more investors to buy these bonds. Since municipalities are issuing BABs, they are issuing less muni bonds. This means that, with fewer munis to choose from, the relative demand for the munis that are available will be higher, and should drive prices higher.
Also, with the massive government debt—about $13 trillion and counting—it is all but a guarantee that tax rates will have to rise. If we see tax rate increases, the relative advantage offered by munis will make these bonds more attractive, increasing demand, which again, should push prices higher.
Historically, ratings agencies like Standard & Poor’s and Moody’s used a relative ratings approach, meaning that their ratings for municipalities were based on the relative strength of a given issuer to other issuers, rather than being based on the probability of default, since so few municipalities ever defaulted. Today, the ratings agencies are updating their ratings criteria to more accurately reflect the potential for default, bringing their muni ratings more in line with their ratings on other types of bonds, such as corporates and mortgage-backed securities. This should have the effect of building more investor confidence in the strength of ratings on munis. More confidence should result in more demand, and again, higher prices. Just this week, Standard & Poor’s downgraded California’s credit rating from A to A-. Most Cal state GOs are insured, providing a AAA rating on the insured bonds.
So, I’ve painted a pretty picture for the future performance of California municipal bonds. But, as all investors know, there are always risks. Here are a few:
First, we do not know how the state of California is going to deal with the crushing budget deficits they (we) face. Second, if interest rates begin to rise, which they almost surely will (and I am convinced they will this year), although munis may outperform treasuries and some other types of bonds, they may still perform poorly. Finally, we are not out of the woods yet with regard to the recession, and if it lingers, or if we get a double-dip recession, we could have further disruptions in the capital markets, resulting in poor performance for all investments.
For local investors who depend on current income generation from their portfolios, and for anyone in a high tax bracket that has some allocation to fixed income, I believe California munis are a good place to be. However, there are a couple of caveats to this recommendation. First, I would focus on Cal state AAA-rated GOs (general obligations). Those willing to do their homework, or who work with a qualified investment advisor, can look for other munis in the state that are issued by trusted municipalities.
Second, I am keeping maturities at five years or less. If rates rise significantly, which I expect to happen, longer maturity bonds will decline by a larger percentage than shorter maturity bonds (all else assumed equal). Rates and prices move in opposite direction, so higher rates generally mean lower prices. By keeping maturities low, investors will not only avoid the full extent of the negative impact of rising rates on muni prices, but will also have opportunities to reinvest at higher yields, as their bonds mature.
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