The tax-free municipal bond market had a very good first quarter of the year as many intermediate- and longer-term bonds rallied back from their beat-up levels of 2013.
Part of this rally was reversion to the mean. We know that bond fund selling from last June through August was responsible for most of the muni back-off. Fund investors ran for the hills at Ben Bernanke’s utterance of the word taper. The fund redemptions, combined with poor liquidity provided by Wall Street firms, sent longer high-grade municipal bond yields rising from 3.5% to well over 5%. After the carnage, most investors realized that those levels were an incredible bargain in a world where inflation was falling rather than rising, where real GDP growth had dropped, and where half of the reduction in unemployment last year came from people who gave up looking for work.
Half of the fall in muni prices has been made up in the first quarter of this year. A number of factors have helped.
Supply has dropped approximately 30% so far this year versus last year. This should be a surprise to no one, as municipalities – most of which are in much better financial shape than they were a few years ago – have the flexibility to wait for a lower rate environment before issuing debt. Also, demand has grown, not only because of the large rollover of maturing bonds, called bonds, and coupon payments that occurs at the beginning of most years but also because some money has probably been reallocated to bonds from stocks in response to higher interest rates. In addition, a number of headwinds have been stirred up in the first quarter (Ukraine, China, and severe winter weather, to name a few).
There has been good news on a number of fronts in the landscape of municipal bonds. Puerto Rico saw its debt pummeled in the last four months of 2013, due to its eroding finances as well as the headline risk from a negative Barron’s article in August that highlighted municipal bond fund exposure to Puerto Rico. However, a $3.5 billion financing in March (below investment-grade and selling at 8.75% yield) provided liquidity to the Commonwealth, and all Puerto Rico debt rallied in the weeks leading up to the financing.
The bond market has also seen a revival among bond insurers. Both Assured Guaranty and National Public Finance (the old MBIA) saw their ratings upgraded by Standard & Poor’s in the first quarter. In addition, many investors saw the value of bond insurance actualized in the case of Detroit’s bankruptcy, as Assured- and MBIA-insured debt has kept paying; and in the case of Puerto Rico debt, the insured debt has vastly outperformed uninsured debt. National Public Finance is expected to start insuring new-issue bonds again; and a new insurer, Build America Mutual (BAM, which is owned in part by the National League of Cities) has also started to do business. Cumberland believes that the existence of healthier municipal bond insurers will expand the pie for insured paper and that this trend will help all insurers as well as the municipal marketplace in general.
Certainly, in our view, longer-maturity municipal bonds offer the best value vis-à-vis the rest of the maturity spectrum. We have tweaked our durations down a touch to reflect the general lowering of yields. However, when longer high-grade municipal bonds can still yield as much as 120% more than longer-term US Treasuries do while five-year muni bonds offer a yield ratio closer to 80%, there is a large defensive aspect to continuing to own longer municipal tax-free paper, and that is part of our strategy.
In summary, the first quarter has benefited from reduced supply, increased demand, a greater asset allocation into munis from equities at the margin, better stories on credit (with the exception of Detroit, which we will address in a separate piece), and – something that is not unusual in the muni world – a reversion to the mean.
John Mousseau, CFA, Executive Vice President & Director of Fixed Income