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A
few months back my colleague Christopher Keith penned an article (The
Benefits of Bonds) in which he profiles an argument for fixed income as part of
a balanced and diversified portfolio. In this article I would like to spotlight
one area of the fixed income market and the opportunities that are present
there: the municipal bond market. Relative Value
With the exceptions of cash and nominal Treasuries, no area
of the market has been unharmed during this period of market upheaval.
Munis are no exception:
Over the past 12 months (ending 10/31/08) the Lehman Municipal Index had
lost 3.30% while the Lehman U.S. Government Index gained 6.82%. Munis have
underperformed Government securities by over 10%. Over the past 20 years,
this is the second largest margin munis have underperformed by over a 12
month period (the largest margin was earlier this year). But it is often
during periods of market dislocation when values can be discovered.
One way that municipal bonds are often evaluated is by comparing their
tax-exempt yields to the yields on similar maturity US Treasuries. This
figure is typically quoted as a percentage of the Treasury’s yield.
For example, if a ten-year municipal bond is yielding 3.20% and a similar
ten-year Treasury yields 4.00%, we would say the municipal bond yields
80% of Treasuries (3.20 / 4.00 = 0.80). As seen below, munis trade at a
long-term average of 80-85% (depending where on the curve you look) of
Treasuries. We would expect this as yields are quoted on a pre-tax basis.
However, as seen in our graph, this relationship recently diverged sharply
from its long-term average. Munis began to yield well in excess of 100%
of Treasuries: Even before taxes, munis currently yield more than Treasuries.
Red Flags
As investors, whenever we are presented with a situation that
varies sharply from the norm or seems too good to be true, red flags should
go up. We
should always ask what created this opportunity? Or what am I missing?
In this particular case, one answer could be that as the economy slows,
municipalities will come under pressure as revenues decline. Municipalities
will then be faced with decisions surrounding budget cuts, tax increases,
and asset sales to meet obligations and balance budgets. With this increased
pressure on municipalities and risk to municipal bonds, it would be logical
for investors to demand higher yields. While this is certainly a factor,
I would argue that it alone does not explain the dramatic spike in the
muni to Treasury ratio.
Safe-Haven?
Munis were historically viewed as a safe-haven by investors
during difficult times. In a report produced by Fidelity, since 1970 less
than 0.1% of all
investment grade bonds have gone into default. If we look at BBB-rated
bonds (lowest rated investment grade), only 0.1% of municipal bonds defaulted
versus 4.6% of corporate bonds.
When we look back at the history of the municipal bond market we see that
even in the rare cases of a default, investors often received full par
and interest with time. One example would be the prominent municipal bankruptcy
of Orange County, CA in 1994. An aggressive leveraging plan and bet on
interest rates pushed Orange County to file for bankruptcy. Out of the
bankruptcy emerged a new bond program with a special tax designated for
the benefit of the new bondholders. The proceeds were used to pay par and
accrued interest to the original bond holders.
Other Factors at Play
So if it is not credit concerns that are entirely
responsible for the dislocation between muni and Treasury yields, what
other factors could
be playing a role? Those factors include liquidity and deleveraging. The
first signs of this were seen in the beginning of the year when auctions
for auction rate securities began to fail as broker/dealers were no longer
willing to absorb (take on to their books) any excess supply. At that time
the muni to Treasury ratio also diverged from the long-term average. However,
as that liquidity issue began to clear, the relationship returned toward
normal levels. In September and October, the muni market saw another round
of deleveraging as hedge funds were forced to unwind their positions. But
it is not only hedge funds that have been forced to sell into this market,
as mutual funds facing redemptions contributed. For example, in mid-October
Schroders announced that they were liquidating two muni bond funds in light
of increased investor redemptions. This forced selling and deleveraging
created an imbalance between supply and demand.
Other factors that played an important role in creating opportunities
in the muni market are fear and uncertainty. The yields on muni money market
funds over the past two months demonstrate how fear and uncertainty affected
the market. Common investments of money market funds are variable rate
demand notes (VRDNs). These instruments pay a variable interest rate (typically
tied to money market yields) and are payable on demand. At their discretion
holders may request repayment of the entire debt and the counter-party
has an obligation to meet the demand. With the collapse of Lehman Brothers
and the "breaking of the buck" by a prominent money market
fund, fear and uncertainty spread across the market. Money market funds
became concerned with the prospect of meeting significant redemptions.
There were also questions about the ability of broker/dealers to meet the
obligation of VRDNs. If this scenario played out and the VRDNs were not
repaid in a timely manner, money markets would be a risk of breaking the
buck. As the chart below demonstrates, rates on money market yields (the
Fidelity AMT-Free Muni Money Market serves as a proxy for national yields)
spiked sharply in September and remained elevated through mid-October.
Actions taken by the US Government have served to alleviate these concerns;
however this serves as another example of the dislocation that affects
the muni market.
Opportunity Remains
In recent weeks the conditions in the municipal market
have improved -- as
seen by the drop in the muni to Treasury ratio and decline in short rates.
As mentioned above, municipalities will face difficulties and continue
to make headlines as their revenues come under pressure. Additionally,
issuance slowed during this recent period of dislocation and supply overhangs
the market. But municipalities have faced numerous economic cycles and
municipal bonds have held up very well through those cycles. The market
will also work through the supply with time, as it has in the past. A rebound
in the muni market is likely to take time and volatility will persist.
However if you believe that markets will stabilize, then munis may be an
attractive alternative to Treasuries. Additionally, if one believes that
tax hikes are inevitable under President-elect Barack Obama, then muni
bonds should be even more attractive.
-- Jeff Demaso, Research Analyst
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