Mark Paccione, CFA, CFP®
CAPTRUST Director | Consulting Research Group
It has been a while since we published on the topic of the municipal bond market. After a poor showing in 2013, municipal bonds are off to a strong 2014 start. The Barclays Municipal Bond Index is up 6 percent through June 30, comparing favorably to taxable bonds and the stock market as measured by the Barclays Aggregate Bond Index (up 3.93 percent) and the S&P 500 Index (up 8.12 percent). Given a few recent and notable developments in the municipal bond landscape, we felt it would be an appropriate time for an update.
Relative Value Restored
Typically, AAA-rated municipal bond yields are lower than comparable U.S. Treasury yields because taxable investors are willing to pay a premium for preferential municipal bond tax treatment. Most municipal bond interest is exempt from federal income tax and often from state income tax, so taxable investors are traditionally willing to accept a lower yield. From 2008 until recently, however, investors demanded higher yields from municipal bonds relative to Treasurys with similar maturities, given that many state and local government finances have been under pressure since the financial crisis. In addition, significant negative publicity heightened investor concerns.
More recently, municipal bonds’ low cost relative to Treasurys has largely dissipated. Figure One shows the ratio of the 10-year AAA-rated municipal bond yield to that of the 10-year U.S. Treasury. A ratio of less than 100 percent indicates that the 10-year AAA-rated municipal bond yield is lower than the 10-year U.S. Treasury yield. As the chart indicates, AAA-rated municipal bonds yielded less than comparable Treasurys prior to 2008. Since the financial crisis, municipal bond yields have often been higher than comparable Treasury yields, thus offering attractive valuations based on the historical relationship. While this ratio is slightly elevated, it is largely back to pre-crisis levels.
Improved Municipal Finances
Tax receipts plummeted for many municipalities in the housing bubble’s aftermath, leaving their finances stressed. While widespread bankruptcies failed to materialize as some predicted, many municipalities were forced to cut expenditures to compensate for declining revenues.1 As the U.S. economic recovery continues, municipal finances are improving, with state and local tax receipts at all-time highs. More impressively, state and local spending remains subdued even as revenue grows. In California, for example, Governor Jerry Brown is battling with his own party to ensure that recent tax windfalls are directed to paying down debt and building a rainy day fund instead of spending.2
Low Municipal Bond Supply
Municipalities are expected to issue fewer bonds in 2014 than in recent years (Figure Two) — even though borrowing is more attractive at today’s low interest rate levels. Because they have constrained their spending even as the growing economy increases revenue, many municipalities no longer have budget deficits to fund through borrowing. As a result, they are focusing bond issues on the refinancing of existing bonds rather than new borrowing. This diminished issuance is constraining supply, pushing municipal bond prices up, and lowering yields.
Low Absolute Yields
While rates did rise in 2013, and most market participants (including CAPTRUST) expect rates to gradually rise over the long term, the bond market has surprised consensus views with declining rates so far this year. With the 10-year AAA-rated municipal bond yield at 2.52 percent as of June 30 (after starting the year at 3 percent), it is now back to levels last seen in June 2013 and, prior to that, in November 2011. While many factors help to explain the recent interest-rate decline, including slowing global economic growth, deflation fears, and geopolitical tensions, many market observers believe unusually low bond supply — not just in the municipal market — contributed to this year’s unexpected interest rate decline.3 Regardless of the cause, interest rates broadly remain at historically low levels, and municipal bonds are no exception, as Figure Three indicates. Investors should continue to expect low-single-digit returns for the typical AAA-rated general obligation intermediate-term municipal bond. Please note that low-single-digit returns do not mean negative returns. While bond returns may be negative over a short period of time, CAPTRUST research has demonstrated that a bond’s current yield is a good indicator of its future returns.
Isolated Municipal Bond Market Issues
While municipal finances have been improving, high-profile issues such as the recent Puerto Rico rating downgrade and Detroit’s bankruptcy persist, causing investor concern. One municipality’s troubles may not directly impact another municipality’s finances; however, investors must monitor issues like those in Puerto Rico and Detroit because the underlying causes and eventual resolutions may affect other municipal bonds in their portfolios. For example, unfunded pension obligations are one factor in the Detroit bankruptcy that is certainly present in other cities and states that may someday impair other municipalities’ abilities to meet financial obligations. In addition, the initial proposed Detroit resolution places pension obligations ahead of general obligation bonds. Traditionally, general obligation bonds have received higher payment priority in bankruptcy proceedings. If the proposal moves forward, municipal bonds may be perceived as riskier due to their diminished seniority in the case of a bankruptcy and may lead some investors to question municipal bonds’ role in more conservative investment portfolios.
Preferential Tax Treatment
Over the past several years, multiple congressional proposals recommended altering municipal bonds’ preferential tax treatment, including limiting the tax-free interest amount an individual can earn or eliminating the tax-exempt status of municipal bond interest altogether. A plan put forth in February by U.S. Representative Dave Camp of Michigan would tax some municipal bond interest earned by individuals in the highest tax bracket; however, no policy or proposal altering municipal bond interest’s tax-exempt status is expected to move forward prior to elections — one small positive consequence of Washington’s current gridlock.4
Overall, the municipal bond market has come a long way since the financial crisis. The economy is on the mend, finances are improving, low supply is bolstering prices, and municipal bonds are not expensive relative to Treasurys. While problem municipalities like Puerto Rico and Detroit exist (and require monitoring), and Washington may someday alter municipal tax policy, investors can take some comfort in the benign municipal bond landscape that exists today. For more information, please contact your CAPTRUST financial advisor.
1 Steve Kroft, Narrator, and James Jacoby, Professor, ”State Budgets: Day of Reckoning,” 60 Minutes. CBS, Dec. 19, 2010
2 Jennifer Medina, “In California, Governor Pushes a Rainy-Day Fund,” New York Times, April 30, 2014, http://www.nytimes.com/2014/05/01/us/with-eye-on-re-election-brown-pushes-rainy-day-fund.html?_r=0
3 Michael Mackenzie, “Supply and demand drive down US bond yields,” FT.com/markets, accessed June 24, 2014, http://www.ft.com/intl/cms/s/0/aa49f496-e7cc-11e3-9af8-00144feabdc0.html - axzz37q814Ebt
4 William Selway, “Muni Tax Break Would Be Curbed Under House Republican’s Revamp,” Bloomberg.com, Feb 26, 2014, http://www.bloomberg.com/news/2014-02-26/muni-tax-break-would-be-curbed-under-house-republican-s-revamp.html