2012 was clearly the year of the birth of the “investment white swan”. Municipal bonds outperformed Treasuries again, and have now become an asset class that has taken on “safe haven” status. As we begin the new year, there remain uncertainties whose answers could impact the underlying value of municipal bonds. You have an asset class that has outperformed since 2006, credit quality that is improving, clueless politicians in D.C., tax-exempt status in question, higher income tax rates and an economy trying to get into gear. Could this be the year that the white swan of investments finally goes under water? Or are we set for an encore performance?
A Review of 2012
Our request in last year’s 2012 Municipal Bond Outlook for greater appreciation for the municipal market was heard loud and clear. 2012 was clearly the year municipal bonds moved up the ladder of sleep well at night investments. In the face of the US economic crisis of 2008-2011, Euro crisis of 2011-2012, and the most recent fiscal cliff crisis, municipal bonds have performed as though unaffected. They have displayed solid credit fundamentals and great risk adjusted returns. More specifically:
Data from Bloomberg and Bank of America Merrill Lynch, show that after adjusting for risk (volatility of prices), munis out returned all asset classes in 2012:
Total return calculations along the curve for municipal bonds during 2012 were as follows according to Municipal Market Advisors:
- 5-Year Index = 1.77%
- 10-Year Index = 4.05%
- 15-Year Index = 6.79%
- 30-Year Index = 8.72%
The trend for municipal credit quality during 2012 shows solid improvements. Municipal Market Advisors shows the pace of defaults in 2012 lagged 2011 by a large amount. More specifically for all municipal bonds, rated or non-rated:
- 93 issuers for a par amount of $1.70 Billion have defaulted. This is 0.43% of issuance in 2012.
- 129 issuers for a par amount of $6.53 Billion this same time last year. This represented 2.24% of issuance in 2011.
2013 Market Outlook – Swan Dive
2013 could be a wild year where market timing, patience and wide access to the municipal underwriting world will be important. At this time, the current risk and return profile for the municipal market is not good for an investor, but things could quickly change. There are numerous risks, as we start 2013, that pose a threat to the current level of municipal valuations. At this time, yields do not seem to take into ac-count these risks and, as a prudent investor, we must be aware of them.
1. Risk/Return profile at these current yield levels does not leave a lot of room for “bad news”. It does not take much of an increase in rates to wipe out a year’s worth of coupon payments.
2. We are closely watching tax reform and the threat that tax-exempt income will not remain fully tax-free. The limit-ing of tax-free income to 28% as a way to help plug the budget gap is still viewed as a threat by the municipal industry. We have seen estimates that, if enacted, could increase borrowing costs for states and localities by 60 to 100bps.
3. Budget cuts could impact the economy, lower aid to states and localities, and decrease subsidies to taxable Build America Bonds. These are all “credit negative” items.
4. TheVolcker Rule, which prohibits banks from making markets on municipal revenue bonds, was scheduled to be implemented in 2013. It now looks like it is being delayed until 2014. This rule, if left unchanged, would hurt the liquidity and, therefore, market value on municipal revenue bonds. The rule, however, does allow banks to make markets on general obligation bonds, which would then create a bifurcated trading market. The delay of implementation is now giving Washington, D.C. a chance to further review the impacts this legislation could have on the various markets.
5. Higher interest rates are looming on the horizon. Just like in 2012, many are forecasting rates to begin rising in 2013. This forecast may finally be right. The economy appears to be moving forward with employment and stocks advancing.
Other Forecasted Highlights 2013
State Autonomy: The polarization of political opinions are beginning to play their way out at the state level. The inability at the federal level to make decisions that satisfy the entire population is causing states to make societal decisions that reflect their population’s demographics. From the legalization of marijuana in Colorado, to gun control measures passed in the state of New York, states are making their own decisions without federal oversight. This is a very important long-term trend, and it’s impact on municipal finance and credit quality is not a topic ready for discussion. States will have different tolerances on “debatable items”, and a population base aligning according to its political views.
General Obligation Bonds: Credit quality should improve for those municipalities with solid demographic characteristics. MainLine has been a big proponent of essential service revenue bonds, and still is, but we are now more comfortable with general obligation bonds.
Beware of the small municipality, non-essential service bond: We are seeing an increase in credit concerns from non-essential service projects from small municipalities that due to fiscal constraints are no longer willing or financially able to support. Municipalities are getting back to providing only the basic services to their citizens, and moral pledges to back debt service may not be enough.
Continued low tax-exempt money market fund rates: Issuance of variable rate notes purchased by money market funds declined 4.82% in 2012, and this will continue. Planned changes in banking regulation over the next 6 years will have banks less willing to back this form of debt with liquidity facilities. This will cause continued decline in issuance and therefore, less supply available for money market funds to purchase. Less supply, no immediate sign of the fed raising rates, and no anticipated change in demand will keep tax-exempt money market rates low. This should provide a nice low borrowing rate for the MainLine West Tax Advantage Funds, and therefore a good payout profile for 2013.
On the positive side, by the end of the year we feel municipal bonds should be a strong performer versus other fixed income investments, if the risks above are handled as we feel they should be. There are several underlying fundamental strengths at play that should see the municipal market through:
1. The supply and demand demographics favor lower municipal rates in 2013. The anticipated new money issuance is lower than the anticipated maturity and coupon payments. This means if municipal investors maintain their current allocation to municipal bonds, there will not be enough new bonds to meet the demand. This will provide a solid appetite for new bond issuance in 2013.
2. Credit quality as measured by default rates and credit default spreads are improving. Therefore, improved credit ratings should follow. State credit default spreads decreased on average 30%, showing changes in the odds of a state defaulting on its debt to have greatly decreased.
3. Higher income tax rates make the after-tax value of municipal bonds look better. If the tax-exemption on municipal bonds does not change during the upcoming budget battles, they will represent even better value than they did in 2012. When comparing taxable to tax-exempt income the top tax payer must now adjust returns by a tax rate of 43.4%. This includes the new 39.4% top income tax rate and the new 3.8% Medicare surtax.
4. Demand for infrastructure projects and a means to finance them are growing. Rebuilding from Hurri-cane Sandy is the initial stimuli, with pent-up needs across the country close behind. P3 Projects (public-private partnerships) are becoming more popular and provide a municipality with a source of financing other than issuing bonds in the municipal market. This could decrease the number of bonds being is-sued in the future for infrastructure projects. Fewer bonds means higher prices for those available.
Investing in 2013
After the strong price performance over the last four years, if an investor is able to clip the tax-exempt coupon, and avoid price losses, that would be a great year. Themes for the year:
1. Discipline: A buy and hold investor, properly diversified, should stay disciplined and continue to reinvest its laddered principal payouts. Stay the long-term course. You may buy some bonds at the low, but will reinvest at higher lev-els in the future. The plan is to have a stable source of income by staying invested. We would advise managing the timing of the reinvestment. See the next theme below.
2. Timing: We would advise careful purchasing and selling, given the risks that lie ahead. This risk could provide opportunities to get money put to work or raise money as fear gets priced in and out of the market. Next month look for an updated “Time to Buy and Time to Sell” review of the municipal market in our upcoming February Monthly Outlook.
3. Get Defensive?: Too much cash due to poor initial reinvestment diversification and the large volume of calls and refunding? Investors with a large portion of cash, or with a new allocation to municipal bonds, should be conservative rushing in and putting monies to work in long-term bonds. There are a few defensive strategies which can provide decent income today, protect price risk, and provide funds over the next two to seven years for reinvestment at anticipated higher rates. Some defensive investment ideas:
- Municipal SIFMA floating rate bonds. We reviewed these as an investment vehicle in the December 2012 Monthly Review.
- Laddered cushion bond strategy when values make sense.
4. Structure is king: Be aware of buying too many low coupon bonds. These bonds could have de minimis issues in the future if rates were to rise, and will underperform in a rising rate environment. Stay diversified regarding reinvestment risk. The most important date to look at for expected principal repayment remains the first call date.
There will be a lot of rough investing waters in 2013, but by year’s end the white swan should still be float-ing. Investors should be ready to take advantage of any market bias as they occur. For a successful 2013, finding value will be important while sticking to your investment plan. The underpriced bond, the defensive structure bond, or the new issue market deal that gets lost or mistimed in the market, need to be the focus in 2013. Just buying a municipal bond and tucking it away, without careful timing and value analysis, could haunt the investor in the years ahead. The risk and return profile at this time deems it so.