The tax-free municipal bond market looks vastly different as we head toward the end of the second quarter of 2011 than it did when we were in the middle of the Meredith Whitney-led meltdown in January of this year.
In January the muni market was battered by the continued onslaught of municipal bond fund redemptions. Most of this damage occurred after Ms. Whitney’s appearance on 60 Minutes in December, when she forecast “hundreds of billions” of municipal defaults in 2011. This started the unmitigated selling, which peaked at over $4 billion per week in January. Because bond fund selling was mostly long-maturity bonds (and the funds own higher-yielding, longer-term bonds to pay their dividends), municipal bond yields soared, with long-term yields reaching 5.15% in the AAA range and between 5.5 and 6% on many high-grade revenue bonds. The bid side was often nonexistent, and liquidity was very spotty.
As Cumberland readers know, the signs were very evident that this was liquidity-driven, not credit-driven. Among these signs was the opposite movement of FALLING yields in the Build America Bonds taxable market, on the very same credits whose yields were being driven higher in the tax-free market. This was because pension funds, foreigners, and other taxable buyers were embracing the municipal credit that the retail investor was rejecting. The other sign was the fact that shorter-term yields had moved very little in the tax-free municipal market – if a true credit event had taken place, yields across the whole maturity spectrum would have moved up sharply.
As we hit the halfway point of the year, we see that 30-year AAA tax-free yields have fallen from 5.11% to 4.37% (source: Bloomberg), a drop of 75 basis points; and 10-year AAA yields have fallen from 3.47% to 2.63%, a drop of 84 basis points. Now, of course, there have been movements in Treasury yields, as well as market concern of a possible slowing economy, that have sent those yields down.
It is important to remember that this is AAA scale. Many high-grade bonds in the A and AA categories traded MUCH cheaper in January. But it is useful to look at the relative value of Treasuries and Munis from January to now. The biggest improvement in ratios was in the 10-year range. But because of the longer duration of 30-year bonds, the biggest improvement in price was in the longer end of the market.
The reasons behind this lie in the fact that most of the damage was in the long-maturity end of the market, since this was where most of the bond fund selling was concentrated. This is the area which could cure the most. Also, new-issue municipals this year are substantially reduced. Part of this was the “move up” of municipal supply at year-end from what would have been early-2011 issuance. This, of course, helped start the downdraft in the muni market in November, as issuers wanted to beat the expiration of the Build America Bonds program. Also, many state and local governments that had flexibility did not issue bonds at the nominally high yields that persisted early this year. We expect the first half of this year to close with approximately $110 billion in issuance. We expect the current lower rates will induce MORE supply in the second half of this year, but 2011 will most likely end up close to $250 billion – a marked decline from recent years.
The overall improvement in municipal finances has also contributed to improvement in the market. State and local governments (in total) are heading toward the sixth quarter in a row of RISING tax receipts. Also, problems in the pension area, which have gotten widespread press coverage, have started to be addressed. We expect this trend to continue.
The selling has abated in the municipal fund arena. Though most weeks have seen outflows, they are much smaller, and there were actually inflows a couple of weeks. Part of this is just the normal abatement of pressures, but it is also the recognition, even among retail investors, that things had really reached a point where the market was severely oversold.
The stock market, after turning in a very good performance through April of this year, has turned jittery with the Dow Jones shedding almost 900 points since the start of May. This has caused somewhat of a re-assessment of the needs of fixed income in overall investment portfolios. Presumably some of the fund selling went into equities and, depending on the timing, these assets could have been whipsawed.
We are now in the middle of a large reinvestment period where approximately $100 billion is rolling off through a mixture of coupon payments, maturing bonds, and called bonds. With fund selling reduced and some wariness in the stock market, we expect a lot of this money to now be reinvested in the bond market.
We realize that, while the municipal market is still cheap on a relative basis in the very short end and in the long end, the “giveaway market” of January and February has certainly turned around. This is causing us to be more cautious from a maturity and duration standpoint as we manage portfolios.
Reprinted with permission from our friends at Cumberland Advisors