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The Battle is Won, But the War is Not Over

Mark Paccione, CFA®, CFP® Director, CAPTRUST Consulting Research Group

Municipal bond investors have been on an emotional rollercoaster over the past several years as these once-sleepy investments have been unusually visible in the news. Following the financial crisis in 2008, concerns centered on municipalities’ ability to repay their obligations in the face of tight state and local budgets. These fears were further stoked in late December 2010 when a respected analyst told 60 Minutes that the financial woes plaguing state and local municipalities have “tentacles as wide as anything I’ve seen. I think next to housing this is the single most important issue in the United States, and certainly the largest threat to the U.S. economy.”1 Yet, while a few high-profile city bankruptcies — such as Vallejo, California and Jefferson County, Alabama — grabbed headlines, wide-scale municipal defaults have not occurred.

More recently, with several proposals circulating that could alter tax policy, municipal bond investors have since shifted their focus to the tax status of municipal bond interest. For example, the much heralded (although unimplemented) Simpson-Bowles Commission called for eliminating the tax-exempt status of municipal bond interest altogether. Most recently, one proposal in the fiscal cliff debate called for capping the municipal bond interest exemption at 28%, meaning a taxpayer in the new 39.6% income tax bracket would pay an income tax of 11.6% (or 39.6% minus 28%) on municipal bond interest. After much political drama, Congress passed the American Taxpayer Relief Act of 2012 on January 1, 2013, and, fortunately for municipal bonds, no changes were made to their tax treatment.
From a relative-value perspective, municipals are attractive when compared to U.S. Treasurys of comparable maturity. Historically, AAA-rated municipal bonds carry lower yields than comparable U.S. Treasurys due to municipals’ taxexempt advantage. However, as Figure 1 illustrates, 10-Year municipal bond yields are trading at a premium to 10-Year Treasury yields. As of December 31, the yield on the Barclays 10-Year Municipal Bond Index was 13% higher than the yield on the 10-Year Treasury. Over time, one would anticipate a return to historical average with municipal bond yields falling more than Treasurys or, more likely, Treasury yields moving higher than municipal bond yields. Either way, municipal bonds remain inexpensive relative to Treasurys.
From a supply and demand point of view, the picture remains favorable as well. As Figure 2 demonstrates, consensus expectations for municipal bond issuance in the coming year are approximately $458 billion.2 While this is an increase from 2012, it is still below levels seen in previous years, indicating expected supply for 2013 is not overwhelming. From a demand perspective, increased tax rates for higher-income earners resulting from the fiscal cliff agreement and recent healthcare legislation should bolster demand going forward. Coupled with their premium to Treasurys, municipal bonds should continue to attract investors seeking yield.
From a fundamental perspective, state and local governments have taken advantage of low interest rates to lower debt costs. As of the third quarter of 2012, debt servicing represented just 5.1% of state and local government *expenditures. This is a minute fraction of the average municipal government’s spending and among the lowest debt service levels of the past 20 years, as Figure 3 indicates. Should the economy and the housing market continue to recover as expected, financial strain on municipalities will ease, providing further support for municipal bonds.
Finally, the municipal bond yield curve remains steep, which allows investors to benefit from holding municipal bonds as they move closer to maturity. All things being equal — and assuming an upward, sloping yield curve — the yield demanded by the market on a bond decreases as it approaches maturity. As the yield decreases, the price of the bond increases. This strategy, known as “rolling down the yield curve,” works best when the yield curve is steep.
Two big concerns remain, notably the overall level of interest rates and potential legislative changes. Prevailing interest rates impact all bond investors. With interest rates at historically low levels, rising interest rates are a risk for most fixed income securities, including municipal bonds. With the Fed committed to maintaining low interest rates for an extended period of time, we do not anticipate a significant jump in rates in the immediate future. Our analysis also indicates that a fixed income portfolio can generate positive returns in a gradually rising interest rate environment. However, the 30-year declining rate tailwind that began in the early 1980s is unlikely to continue for the next 30 years.
We believe that, if and when rates begin to rise, the positive factors discussed earlier will provide some cushion, although investors who have not done so already should consider moving away from longer-maturity bonds, which are more interest-rate sensitive than shorter-dated bonds, and utilize lower-volatility alternative investment strategies that are not sensitive to interest rate moves.
The second main concern for municipal bond investors is the potential for passage of legislation that calls into question the tax-exempt status of municipal bond interest. While many believe that completely eliminating the exemption municipal bond interest is unlikely, issues surrounding federal spending and deficits remain unsettled. Proposals such as taxing municipal bond investors over the 28% limit may resurface. If they do, it will be important to analyze the potential impact of the particular proposal in question. Investors should remain vigilant, monitoring developments out of Washington for the foreseeable future.
The once-sleepy world of municipal bonds has had its share of excitement over the past several years. While municipal bond investors have remained unscathed so far, and municipal bonds remain an attractive investment, investors will need to navigate a less friendly interest rate environment and keep an eye out for unexpected policy developments moving forward. As always, CAPTRUST is here to help you achieve this objective.