About a year ago, some analysts predicted that tax-free bonds would suffer the same unseemly fate as did their distant cousins in the sub-prime mortgage market. Default rates in the municipal sector were projected to soar as damage from the Great Recession tore into state and local government revenues.
Things didn't turn out quite that way.
Heightened volatility notwithstanding, municipal bonds posted solid gains in 2011, in addition to generating income that is generally free from federal income tax.
"We weren't as concerned about the overall tax-free bond market as some of the naysayers, but we're not letting our guard down either," says Timothy McGregor, director of municipal fixed income at Northern Trust. "Discriminating between worthy and unworthy credits is critical in this fragile economic environment."
Impact from Europe
With the U.S. labor and housing markets gaining some traction since fall, most of the recent macro-economic worries have centered around Europe.
Yet even though the European debt crisis might seem to have little to do with the success of, say, a stadium project in Any Town, USA, there is a connection.
When investor sentiment towards Europe and the global economy improved in early 2011, money poured out of safe haven assets like U.S. Treasury bonds and into stocks and commodities.
Since municipal yields track those in the Treasury market — albeit imprecisely — the sell-off in government bonds spilled over into the tax-exempt sector as well, exacerbating the impact of lingering concerns about local government finances.
Between October 2010, when some of the first warnings about possible municipal defaults were sounded, and April 2011, when the eurozone crisis was flaring anew, the yield on Moody's 20-Bond Municipal Bond Index climbed from less than 4% to more than 5%, a significant backup in rates from such a low level.1 Muni bond prices, which move inversely to yields, plunged accordingly.
The reluctance of risk-averse and capital-constrained broker-dealers to function in their traditional role of buffer during periods of waning liquidity contributed to the volatility as well.
Market technicals and European debt issues aside, however, the tight finances of some state and local governments and the projects they funded are a key reason why the muni market has been more volatile than usual — and why it could stay that way for years to come.
Fears of rising defaults, though perhaps overblown, are not without theoretical justification.
This time is different
The current U.S. recovery is unlike most others during the post-World War II era. Recessions during the last 70 years typically were caused by the Federal Reserve using higher interest rates to dampen rising inflation.
When the inflationary fever broke, the Fed normally took its foot off the brake, economic growth resumed and municipal finances recovered.
This time, not so much.
The 2008 financial crisis triggered a "balance sheet" recession in which overleveraged households, corporations and governments were forced to cut spending. Balance sheet recessions are the toughest to cure, since reigniting growth by lowering the cost of credit in a debt-soaked world is like trying to light a soggy match.
If the eurozone crisis were to intensify, the impact on the global economy would only add to existing stresses on municipal balance sheets.
So even though defaults within the tax-exempt sector have declined since 2008 — and municipal revenues, with the exception of property taxes have begun to recover — McGregor says diligent credit research is critical now more than ever.
"Municipal budgets will be tight for the next several years and certain sectors could still face serious funding issues," he says.
Those at-risk sectors include health care, where industry overcapacity and a cutback in federal matching funds to the states could spell trouble, and bonds that require regular legislative approval to meet debt service.
Such bonds typically pay a higher interest rate, but McGregor isn't tempted.
"You don't want to depend on a vote from politicians to get your money back," he said. "A bond issue may have funded a project that isn't paying its way, and legislators could decide to just let it go. It never makes sense to jeopardize your principal to pick up a few extra basis points in yield."
Arch King, senior product manager for municipal fixed income at Northern Trust, notes that the firm's culture emphasizes credit quality and proprietary research and, thus, has tended to steer investments away from lower-rated debt, especially in the municipal sector.
"We don't think that our investors buy municipal bonds to take undue credit risk," King says. "If they want exposure to riskier assets, there are other ways to get it."
Digging for opportunity
McGregor thinks that Northern Trust's intensive bottom-up research capability can help to uncover pockets of relative value in the inefficient $3 trillion municipal bond market, which is comprised of about 50,000 issuers.
Plus, he says, there are ways to boost yield without taking undue credit risk.
Among those strategies is understanding market "technicals," or the balance between the upcoming supply of bonds and the potential demand for them. "That's a factor we monitor every minute of every day," McGregor says.
Another way to get more bang for the credit buck is to overweight those states, sectors and portions of the yield curve that could generate the most income per unit of credit risk.
"Interest rate risk is a fact of investment life, but we think we can manage that risk prudently utilizing the entire yield curve to get the duration exposure we think is right under the circumstances," McGregor says.
Just don't ask McGregor to pump up yield by placing hopeful bets on unworthy credits. "We're not willing to compromise on credit issues," he says. "Our conservative philosophy doesn't need to change and it won't change."
McGregor cautions that in a low interest rate environment, some investors and professional managers are tempted to "stretch" for yield. But such exercises "usually don't end in a good way," he says.
Even though the secular underpinnings of the muni market — an aging population needing retirement income and potential tax hikes on the horizon — still look good, McGregor says volatility isn't going away any time soon.
Yet choppy markets can create opportunity as well. The highly uncertain economic outlook, for instance, has made munis unusually attractive compared with Treasuries.
As of January, some highly-rated municipal bonds yielded more than equivalent maturity Treasuries, even before the federal income tax benefit was calculated. In those cases, investors could have received more income after taxes from the municipal bond than they would before taxes from the Treasury security.2
"Our shareholders like that," McGregor says. "So do I."
According to McGregor, lingering fears about Europe and credit concerns in the municipal market are keeping tax-free yields elevated compared with Treasuries.
Which is just fine, McGregor says. Though he hasn't necessarily agreed with the doom-and-gloom crowd, the bargains their well-publicized warnings wrought are nice all the same.
"We took advantage of the scares that have been thrown at the market because they created income opportunities that we wouldn't have had otherwise," he said. "If there weren't people claiming that the sky is falling, we wouldn't have been able to purchase high-quality bonds at the attractive prices that we did."
However opportunities in the muni market might appear in the future, McGregor and his team plan to keep watching out.
And looking up.
Past performance is no guarantee of future performance.
Investing involves risk including the possible loss of principal. Income from municipal bonds may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax.
1 Federal Reserve Board
2 Federal Reserve Board