Municipal Bonds: Oversold and Undervalued
Investors are understandably concerned about the recent sell-off in the municipal bond market. Conservative investors look to municipal bonds for capital preservation, tax-free income, and diversification. Yet, the sell-off in municipal bonds must be viewed within a larger context, and as recent events have shown, municipal bond markets have become swept up in the turmoil that has rattled financial and commodity markets in recent days. A variety of domestic and foreign factors share responsibility for this renewed period of market turbulence.
The most prominent domestic source of market anxiety is a growing view that the Federal Reserve is closer to the end of quantitative easing than the beginning. Market concern that the Federal Reserve may begin to reduce the expansion of its balance sheet and taper its bond buying program has been a catalyst for interest rates to move higher and stock prices to move lower.
The Fed’s bond buying program, currently at a rate of about $85 billion per month, has indeed kept a lid on the level of interest rates. As Exhibit 3 to the right shows, the 10-Year Treasury has been in a very clear trading range since August 2011. However, the Treasury market has swiftly begun to test just how high the Fed is willing to let rates go, and Treasury yields are now at the higher end of this nearly 2-year range. As Exhibit 4 shows, the Fed now owns a substantial portion of the outstanding Treasury and TIPS markets. It is particularly present in longer maturities as part of its effort to hold rates down.
In that context, the market’s concern that the Fed will buy fewer Treasuries is a legitimate one. Yet, the Fed has expressed clear goals for the economy, with specific forecasts for the unemployment rate and inflation. In all of the market turmoil in recent days, many investors have lost sight of the fact that recent economic data has shown that the level of inflation (currently at 1.4%) is falling back towards deflation, not the Fed’s 2% target, and the level of unemployment, at 7.6%, remains stubbornly high relative to the Fed’s target of 7.0%. Needless to say, if we take the Fed at its word, that its purchase program will diminish as the economy hits its stride – namely as inflation rises and unemployment falls – we can reasonably raise the questions: Have the financial markets overreacted? Are municipal bonds now oversold and undervalued?
Before we answer, let’s reflect on the broader context for this correction in municipal bond prices. The municipal bond market, as well as domestic and foreign stocks, commodities, and foreign currencies were all under pressure during this period. The drop in these markets was not only a Fed-related phenomenon, but an event whose parentage is shared by China as well. As growth expectations in the rest of the world faltered, markets began to rely on Asia as a savior of global growth and the drop in China’s purchasing manager’s report to a level consistent with an economic slowdown deeply worried markets, and prices readjusted accordingly.
We may have thought that the markets had moved beyond the “risk-on” and “risk off” oscillations that characterized market behavior in the immediate aftermath of the 2008 Financial Crisis, but old habits die hard. In the face of uncertainty – about the world after the Fed intervention ends and China’s ability to deliver on growth – markets have returned to the “risk-off” trade like a warm blanket and correlations have moved back towards one. Looking at the data over a 10 year period, we see what we would expect, that municipal bonds as represented by the Barclays Capital Municipal 5 Year Index have a low correlation to stocks. In the turbulent week just concluded, however, we can see that the municipal bond market, along with all other market sectors, correlate very highly with stocks. This is an unusual phenomenon that is not likely to persist.
As markets across the globe corrected, investors may have been concerned by a drop in the value of their municipal bond portfolios. To address these concerns we will first discuss the current valuation of the municipal bond market, the source of municipal bond returns over time, and the opportunities presented by the recent correction. Then, we will use the recent correction as a diagnostic – a way to discuss the risk/return trade-offs of different municipal strategies. Some investors, in the search for yield, have reached for longer-maturity bonds without consideration of risk. Recent weeks are a fresh reminder that there is no free lunch, that extra return comes with a price – extra credit risk and price volatility – and investors need to make sure they are comfortable with the risk profile of their investments.
The most traditional municipal bond valuation measure is the ratio between municipal and Treasury yields. As Treasuries are taxed, and municipals are not, municipal yields should generally be lower than 100% of Treasury yields. The average ratio of the 10 year municipal yield to Treasury yield has been approximately 85% since 1988. Since the financial crisis, municipal bonds have generally traded at cheaper valuations than their pre-crisis norms. Yet, in recent weeks municipal bond valuations have cheapened further.
As Exhibit 6 shows, ratios for AA and A rated municipals have risen to the highest levels in a while.
Considering that municipal credit quality has generally improved for most credits in recent years (a notable exception to be discussed shortly), the current level of ratios is not consistent with the improved credit fundamentals for the municipal market. There are other factors that drive the valuation of municipal securities beyond credit fundamentals, and as Adam Smith would remind us, supply and demand also must be factored into the valuation equation.
Investors in municipal bond funds have redeemed their holdings at an accelerating rate in recent weeks. When a municipal bond portfolio manager raises cash for redemptions, the fund typically has limited discretion regarding the timing of the sales to meet those redemptions. Whether the market is richly or cheaply valued, the bonds must be sold. To complicate matters, the bond sales have occurred at a time when the dealer community is less willing to purchase securities and less willing to hold them in their own inventories for an extended period of time. Not only are there fewer dealers since the financial crisis, who want to maintain smaller positions overall, but we are within days of a quarter-end when dealers typically seek to show smaller balance sheets to the outside world. And, they have been having trouble meeting this goal. Recent data has shown that dealer inventories have actually risen, an unwanted occurrence for dealers less willing to hold inventory. All of these factors have likely contributed to a drop in liquidity in all fixed income markets and this has created value not only for municipal buyers, but for corporate investors as well – more on that in a moment.
The selling pressure on the municipal bond market is most evident in the recent behavior of the iShares Municipal Bond Fund ETF (MUB). This fund has become a popular investment with many retail investors and has approximately $3.5 billion in assets under management. While the assets in this fund are modest in the context of the overall industry, it had been gaining in popularity. Investors have been attracted to this fund due to its yield, and the ease with which they can move in and out of this investment. In recent weeks, the share price of this fund has been trading at a growing discount to the fund’s net asset value. This means that investors are so bearish on municipal bonds that they are willing to sell this fund at a share price beneath the value of the assets. Behavioral economics seeks to understand how the mindset of investors impacts their behavior and in turn, financial market prices. If we use MUB as an indicator of market psychology, and if we accept the premise that selling assets at a discount can represent a market trading at an oversold condition, it seems reasonable to conclude that MUB is telling us the municipal market is now oversold, and investors are acting in a manner consistent with bearish extremes. Since its launch in 2007, intermediate bottoms in the municipal market have tended to coincide with periods when MUB trades at a discount.
Importantly, and interestingly, MUB is not alone – the municipal closed-end bond universe represents a sizable portion of the market with approximately $61 billion in assets and of the more than 200 closed end funds that we track, almost all are trading at a discount to net assets. Not only does this represent another important coincident indicator suggesting the municipal bond market is oversold, it also represents an interesting investment opportunity. In this oversold market environment, the total return opportunity for municipals may be quite attractive, particularly relative to other asset classes during times of stress.
An important way for an investor to consider the risks of a short, intermediate, or longer-term maturity municipal strategy is to look the potential volatility and drawdown of a strategy in addition to its returns. We use the Barclays 3-Year Municipal Index, the Barclays 1-10 Year Index, and the 1-15-Year Index to represent these different maturity strategies, as shown in Exhibit 7. Longer maturity strategies have historically had higher volatility and greater drawdowns than shorter maturity strategies.
There are other risks on the horizon we should note, however isolated they may be to issuer-specific circumstances. On June 14th Kevyn Orr, the Emergency Manager for the City for Detroit (rated Caa2 by Moody’s), released his first “Proposal for Creditors,” in which he announced that the City would suspend making debt service payments on its unsecured obligations. This included defaulting on a $39.7 million payment on its pension obligation bonds due on that date. The manager laid out a thorough case for the city’s insolvency and detailed the immense challenges that lay ahead for Detroit.
Financial distress in Detroit is not a new event, the city has been financially deteriorating for many years and these challenges are both massive and widely known. They include a 63% population decline since 1950, a high tax burden on a population with low income levels, elevated unemployment, high crime rates, repeated deficits and rising pension costs. While these issues are striking, the most significant aspect of the proposal for the municipal market was the inclusion of General Obligation bondholders as “unsecured creditors.” Classifying General Obligation bonds as unsecured breaks with the fundamental traditions of the municipal market – namely that unsecured creditors rank subordinate to General Obligation debt. The city’s proposal for restructuring its debt obligations raises some concerns. However, the proposal is not a legal judgment and can be thought of as the “first shot fired” by an emergency manager seeking to set the tone in what will be a long and difficult negotiation process.
It is important to reiterate that Samson performs thorough fundamental analysis on each credit and only purchases the debt of very strong and stable issuers. While there are broad challenges facing local governments and we do maintain a negative outlook on local general obligation debt, the issues are generally on much smaller and more manageable scale than seen in Detroit. The broad sector challenges include a mediocre recovery in revenues since the recession, local funding cuts used to balance state budgets, expenditure pressures after years of austerity and rising pension costs. While our conservative approach to municipal investing has kept us far away from credits like Detroit, we will continue to monitor the developments as negotiations advance.
At this point, while we view events in Detroit as specific to that city, should this issue become a larger concern, we will act proactively to diversify portfolios more broadly into taxable securities if appropriate. At this time it is important to emphasize we do view events in Detroit as isolated.
Earlier, we mentioned corporates. Not only has this sector been hit by many of the same technical forces that have impacted municipals, but certain high quality issues are trading at spreads and yield levels that are comparable or higher than municipals on an after-tax yield basis. Just as municipal credit has generally improved in recent years, this corporate spread widening has occurred against a backdrop of improved corporate fundamentals as well.
Looking forward, we will seek to navigate the opportunities and challenges of the markets with our conservative investment process – grounded in fundamental credit analysis, within our conservative risk management techniques, and mindful of the macro-economic forces and technical market conditions that can impact portfolio valuations.
In spite of market headwinds, we are cautiously optimistic about the municipal market as we head into the 3rd quarter. This is a time that has traditionally been constructive for the municipal market, as a significant portion of the market pays coupons during the period immediately ahead of us, leading to reinvestment, and thus demand for the sector. Yet, this summer is a time when municipal supply is actually projected to shrink due to the large number of bonds that will be maturing in the months ahead. Negative supply, plus rising cash flows reinvested in the sector, present a positive supply/demand backdrop for municipals as we enter the second half of the year. Current estimates for negative municipal supply are -$13.8 billion for July and -$5.5 billion for August.
During these volatile times it is particularly important to remember the most fundamental reasons for owning municipal bonds. For tax paying investors, they offer after-tax returns superior to many other investments on a risk adjusted basis. At a time when taxes are more likely to go up than down, municipal yields well above Treasury yields are an extraordinary value. Investors have much to consider as they reflect on the new risk landscape that Chairman Bernanke has just unveiled.
Chief Investment Officer
June 21, 2013
Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. Certain information herein was obtained from third party sources which we believe to be reliable, but Samson cannot guarantee the veracity of the information.
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