Higher Volatility in the Muni Bond Market has Continued to Drive Focus on Selectivity and Research

April 2011

The usually-calm municipal bond market has been making headlines lately, as the budget woes facing several states and municipalities have helped spark investor interest and concern. Northern Trust’s Tim McGregor, director of municipal fixed income, addresses some of the issues facing today’s municipal bond investors.

What factors have been affecting the municipal bond market?
A combination of factors has generated higher-than-usual municipal bond market volatility in recent months. In particular, an unexpected increase in rates, stemming from the Federal Reserve's latest quantitative easing program (QE2) and improving economic growth data, drove down prices in the Treasury and municipal bond markets in late 2010 and January 2011.

Other issues likely to remain in the forefront involve credit concerns and the growing media coverage of budget challenges facing many states and municipalities. The market's sensitivity to credit and budget factors is unlikely to abate during the rest of the year and may actually increase as specific, localized situations capture the attention of the media. Nevertheless, it's important to remember that defaults among rated municipal securities are rare, and most of the defaults in recent years involved non-rated and below-investment-grade bonds, particularly in the real estate development industry — areas of the market the investment-grade municipal bond funds in the Northern Funds family have avoided.

Against a backdrop of mounting fiscal and budget problems, how do you select municipal bonds?
Given the headline-making credit and budget issues facing many state and local governments, it's crucial to point out the important distinctions between different types of municipal bonds. Making blanket decisions about a specific state or municipality may not be the best way to invest in this market. Any market with more than 50,000 issuers and more than 1.5 million outstanding issues will have an array of good, bad and ugly credit profiles. Northern Trust's proprietary credit research process is designed to make sure we know and act on those distinctions.

We have always been highly selective with regard to factors such as credit, structure and geography. Rather than identifying specific issuers to avoid, we focus on proactively identifying specific issues with attractive attributes. For example, the source of a bond's repayment is a significant factor. Currently, we favor revenue bonds, especially selected essential service bonds, which may feature income streams that particularly protect bondholders. We have also found value in certain general obligation bonds, primarily those tied to more flexible and reliable tax revenue streams. We have generally been avoiding bonds backed by discretionary or appropriation-based payments.

In the past, some managers and investors have focused more on capturing the highest-available yield in the municipal bond market rather than carefully researching the underlying credit quality of specific issues. That strategy worked in 2009 and much of 2010. But starting late in 2010, it appears that many municipal bond investors became more attuned to the strategy we have been consistently pursuing: identifying and seeking to capitalize on the specific characteristics of individual municipal issues. For example, a disaster like the recent earthquake and tsunami in Japan might have triggered a selloff among all municipal utility bonds. Instead, investors appear to have taken a closer look at the individual issuers throughout the municipal power industry and distinguished those with nuclear sources from those that use coal or natural gas.

Has the extension of prevailing federal income tax rates for all taxpayers dampened demand for municipal bonds?
In late 2010, uncertainty surrounding future federal income tax rates was unsettling for many municipal bond investors. One concern was that the extension of prevailing tax rates might diminish the demand for municipal bonds. So far, this fear appears to be unfounded. We think overall tax levels and investor demographics will continue to attract many investors seeking tax-advantaged investment alternatives.

While federal income tax rates will remain the same until 2013, many cash-strapped state and local governments are raising taxes now as part of addressing their budget shortfalls. In that sense, the overall tax rates for many individuals are rising, which supports the attractiveness of municipal bonds for investors with higher state and local taxes.

Furthermore, the baby boomer generation has started turning 65, and many may want to increase their exposure to fixed-income investments to generate income and reduce overall portfolio volatility. The municipal bond sector is not the only fixed-income category investors use to achieve those goals. But it is likely to attract new investors entering retirement and seeking the benefits of tax-free investment income.

What is your municipal bond outlook for the remainder of the year?
States setting their budgets for the upcoming fiscal year will have to do so without additional federal stimulus support. Many states are solving part of their own shortfalls by reducing support to other, especially local, levels of government — a "reverse waterfall" of aid. Therefore, we expect many state and local governments will exhibit fiscal discipline through a combination of spending cuts and tax increases. We believe the municipal credit environment will remain challenging, and thus we want to "stay at the top of the budget," by selectively owning essential service revenue bonds and general obligation bonds, rather than "being at the bottom of the budget," with appropriation bonds or leases.

Municipal bond supply is likely to remain constrained throughout the rest of the year, as issuers cancel or postpone pending projects and use bond proceeds raised in prior years. Additionally, the municipal yield curve is still historically steep, so investors are being rewarded for extending duration. In this market, we'd rather extend duration to increase income than take on additional credit risk. As such, we continue to favor securities with AAA and AA credit ratings. We believe well-researched municipal bonds continue to offer the benefits of favorable tax-exempt income and diversification in a well-rounded portfolio.

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.

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