It’s not exactly a riddle wrapped in a conundrum, but it does have investors scratching their heads.
Local government finances are wobbly. In some cases, very wobbly. The three main pillars of municipal finance — income, sales and property taxes — each were weakened by the Great Recession.
Yet despite a handful of menacing headlines — most of which concern specific ill-conceived projects begun years ago — tax-free municipal bonds fared quite well during the economic downturn, thank you.
The Barclays Capital Municipal Bond Index returned an average of 6.04% for the three-year period ending September 30, 2010.1 A good portion of those gains include income that is free from federal tax, further boosting the sector’s attractiveness.
This strong performance begs the question: Why have municipal bonds thrived while local government finances are under pressure?
“Slow growth, low inflation and a Federal Reserve that seems to be on permanent hold,” said Timothy McGregor, director of municipal fixed income at Northern Trust. “The macro-economic fundamentals have been supportive of tax-exempt bonds.”
Market interest rates are a major driver of muni-bond performance, and yields have plunged along with the pace of economic activity. In mid-2007 — about a year before the global economic storm hit — 10-year Treasuries yielded more than 5%. By mid-2010, that number had sunk below 3%.2
Since bond prices move inversely to interest rates, the market value of most tax-exempt bonds rose during that period.
As McGregor notes, a gloomy economic outlook also has helped the muni sector.
After most recessions, the Fed takes away the monetary punch bowl when it’s clear the economy has sufficiently imbibed on cheap money. This time, benchmark rates have stayed at rock-bottom levels more than a year into the recovery. That’s because policymakers don’t foresee a return to normal growth rates any time soon.
In addition, the eurozone debt crisis spurred a stampede into safe havens like U.S. government bonds, pushing their yields lower still. Though municipal and Treasury yields don’t move in lock step, they generally move in the same direction.
“In this case, they both moved down,” says McGregor.
Inflation or deflation?
Now the question is whether they’ll stay down.
One factor that could push rates up is higher inflation. But with unemployment near double-digits, inflationary pressures are expected to remain modest. Many households are either paying down debt or hoarding cash.
Some economists are more worried about deflation. They cite Japan’s 20-year battle with falling prices following the bursting of its twin asset bubbles (stocks and real estate) as a harbinger of what could happen here.
Not everyone agrees with that dour assessment, though most high-quality bonds would probably benefit from falling consumer prices.
Even assuming deflation fears sparked excesses in some areas of the fixed-income market — Treasuries are the prime suspect — municipals could be suffering from a case of guilt by association.
“The domestic bond market is a diverse group that shouldn’t be painted with a single broad brush,” says Arch King, senior product manager for municipal fixed-income at Northern Trust. “Certain sectors can be expensive while others remain fairly valued or even cheap.” Indeed, some tax-advantaged municipal bonds still yield more than taxable Treasuries.
King acknowledges that yields cratered on Treasury bills, notes and bonds as investors worldwide sought protection from the uncertain economic environment. But with 10-year Treasuries yielding less than 3%, it’s debatable if that sector is unreasonably expensive given that core inflation is running at the lowest level since the early 1960s. The Fed would like to see inflation a tad higher.
“Yields are low for a reason,” says King.
Even after the economy recovers, structural forces could support high-quality tax-exempt bonds for years to come. Of course, cyclical and technical factors will push yields up and down over short periods, but the long-term outlook seems favorable.
“From a secular perspective, we like what we see,” says McGregor. He lists several factors likely to generate an enduring tailwind for the municipal sector:
Surging demand. Those 78 million baby boomers aren’t exactly spring chickens anymore. The graying of America, combined with increased longevity, imply a steady appetite for investments that generate income. The fact that many boomers are behind on their savings and no longer can depend on corporate pensions also could sustain heightened demand. “Boomers are entering their fixed-income years, which is a positive for the muni market,” says McGregor.
Shrinking supply. The introduction of Build America Bonds (BAB) as part of the economic stimulus legislation last year cut sharply into the supply of traditional, tax-exempt munis. McGregor calls the BAB program one of the most significant developments in the municipal market that he’s experienced during his long career. Though considered a municipal security, interest on BABs is taxable, with the federal government subsidizing 35% of the higher cost as part of a two-year program that McGregor expects to be continued (though at a lower federal subsidy) and possibly expanded to cover the refunding of maturing munis.
Though total municipal issuance was roughly flat during the first eight months of the year compared with 2009, new supply of traditional tax-exempt bonds was down by about 20%. “That’s a massive amount,” says McGregor, who notes that institutional investors are warming to the BAB program. “What they’ve purchased so far is a drop in the bucket compared to their potential buying power.”
Taxes. Nearly everyone agrees that some combination of tax hikes and spending cuts are needed to keep the United States out of serious financial trouble down the road. It’s a good bet that any tax hikes will hit upper-income households the hardest. The ways of Washington are hard to predict, but King has some thoughts on the matter. “I don’t know if taxes are going up, but I’m pretty sure they’re not going down,” he says.
Compared to the federal government, municipal finances generally aren’t in bad shape. According to Morningstar, debt burdens as a share of gross state product range from 0% to 7%.3 By comparison, publicly held federal debt is 62% of GDP — and rising fast.4 Of course, it helps that the Treasury can print money to pay its bills, an option not available to the states.
But just as the various sectors of the domestic bond market don’t move in synch, sharp divergences can occur within a sector as well. That’s another way of saying there are pockets of stress in the municipal market.
Several states, including California, Pennsylvania, Illinois and Nevada, have made headlines for the wrong reasons. In August, the Securities and Exchange Commission charged that New Jersey understated liabilities associated with its two largest pension funds; 79 bonds issued between 2001 and 2007 and worth more than $26 billion were involved in the alleged misrepresentation.5
“The New Jersey pension shortfalls are another example of why we take proprietary research so seriously,” says McGregor. “We look at outside opinions, but they are not the last word. Far from it.”
Historically, the municipal sector has enjoyed a relatively pristine credit history. But that’s not to say that local governments always pay up. During the past the 38 years through 2007, Moody’s counted 54 defaults among municipal issues.
During that same period, however, corporate defaults totaled about 1,700, according to Moody’s. Another study found that investment-grade municipal bonds had a default rate of just 0.16% from 1986 through 2008, with no defaults occurring among issues rated AAA.6
“You can’t drive by looking in the rear-view mirror,” says King, “but highly rated municipal bonds do have a very strong credit history.”
Besides general weakness in the tax base, there are budgetary uncertainties involving Medicare that could affect state finances. The wild card in the equation is whether the federal government will increase its contribution.
At least four states — Minnesota, Missouri, Ohio and Texas — have not budgeted for additional help. Planning for a worst-case scenario is good for bondholders. But California, Florida, Illinois, New York and Pennsylvania are projecting more federal aid, making them vulnerable if Washington doesn’t ride to the rescue.
McGregor is especially leery of issues backed by discretionary tax dollars.
“Bonds that require a new appropriation every year to pay the debt service are too risky,” he says. With political leaders under intense pressure to balance their books without raising taxes — and with voters in no mood to authorize more spending — defaults in the discretionary sector could rise significantly in coming years.
Yet McGregor is having no trouble finding high-quality tax-exempt bonds trading at reasonable prices. The municipal market is immense, comprised of nearly $3 trillion in outstanding issues.
McGregor prefers dedicated revenue bonds, which pay interest directly to creditors without first requiring legislative action. Even in this group, however, he stays with issues that finance economically viable projects like water, sewer, power and transportation facilities.
“Those areas still provide good value,” he says. “The negative headlines have actually helped by keeping prices cheaper than they would be otherwise.” He advises avoiding such sectors as healthcare and housing, which historically have above-average default rates and which remain under pressure.
Calling the tune
Northern Funds mutual fund managers are using their deep connections within the muni market to get bond documents drawn up precisely to their liking. With broker-dealers now playing less of a role in the underwriting process, McGregor and colleagues exert considerable influence in establishing debt-service reserve funds, rate covenants and additional financing tests.
Still, credit risk is an expanding cloud on the municipal horizon and argues strongly for caution, experience and prudence.
“We’ll do what we always do — dive deep into the fine print — to uncover solid credits selling at reasonable prices,” says McGregor. “If you’re an opportunistic investor in high-quality bonds, this is a good environment in which to operate.”
So stop it with the head scratching. And enjoy some tax-free income.
Past performance is no guarantee of future results.
Mutual fund investing involves risk, including loss of principal.
Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.
Tax-Free/AMT Risk: Tax-exempt funds’ income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax.
1 Barclays Capital.
2 Federal Reserve.
3 Miriam Sjoblom. “How Scary are Municipal Finances?” Morningstar (Fund Spy). August 23, 2010.
4 Jeanne Sahadi. “CBO Chief: Budget Outlook ‘Daunting’.” CNNMoney.com.
July 1, 2010
5 Northern Trust.
6 Chapman and Cutler LLP.