Thought Leadership

Tapering: The Difference Between Municipals and Treasuries

December 19, 2013

Yesterday, the Federal Reserve announced that it will begin tapering its bond purchases in January. The Fed will reduce its bond purchases from $85 billion a month to $75 billion a month. Treasury and mortgage-backed security purchases will be reduced equally by $5 billion a month. The market responded with a modest rise in yields that has continued today. While yields have increased noticeably, the jump in yields that many feared did not materialize. Perhaps this is the bond market’s way of saluting Chairman Bernanke’s efforts at greater transparency in the tapering discussion. Before yesterday, the bond market had been roiled by two distinct waves of taper tantrums. These taper tantrums, discussed below, involved a rise in yields and a steeper treasury yield curve. As Chairman Bernanke reiterated yesterday, the Fed does not want a surge in rates to derail a housing market recovery and the Fed will adjust its policies accordingly to make sure recovery continues. Yesterday’s muted market response suggests bond investors are finally getting the message.

A review of the two taper tantrums that swept the market before yesterday can help us better understand the risks and opportunities ahead. The first wave of bond market taper tantrums began in the spring and concluded in early September when the Fed clarified its conditions for tapering. During this first period of market concern about tapering, shaded at left, interest rates rose and both municipal and Treasury curve slopes steepened dramatically and in a consistent manner. Following the Fed’s September announcement that tapering would only occur if the level of unemployment fell beneath 6.5% and the level of inflation rose above 2%, bond markets rallied and the slope of municipal and Treasury curves flattened once more. Though the Fed was clear about the conditions for tapering, by the end of October the bond market began a second wave of taper tantrums.

This second wave, also shaded at left, has not been as severe as the first wave. In part, this could be a sign of growing maturity in the psyche of the bond market. After all, in order to calm the markets, the Fed has supplied additional information about the likely future course of tapering and tightening. Yesterday’s announcement provided additional clarity. The Fed has been clear that any tapering will be gradual. And, most importantly, the Fed has been very clear that it will not raise the Fed Funds rate until the economy truly accelerates and CPI rises meaningfully above 2%. As the chart to the left shows, inflation is falling, not rising, and the Fed will need to be accommodative to make sure the economy does not fall into a deflationary spiral. While the prospect of tapering has alarmed the bond market, the additional forward guidance from the Fed has had a calming influence. This can be seen not only in the comparison of how the market behaved in the first and second taper tantrums (the second event has been less severe), but also in the behavior of the Merrill Lynch Option Volatility Estimate (MOVE) Index, as shown in the chart to the right. The MOVE Index, the bond market version of the VIX, measures the worry of bond market investors by capturing the implied volatility of Treasury options for various points along the yield curve. While volatility rose during the 4th quarter’s taper tantrum, it has remained far beneath the levels seen in the first taper tantrum that began in the spring.

Where do we go from here? Now that the Fed has announced the size of its tapering program, a cloud of uncertainty has been lifted from the market. Starting in January the Fed will reduce its bond purchases from $85 billion in securities a month to $75 billion a month. This means the Fed will be buying $120 billion dollars less on an annual basis. The flip side of that equation is that it still means the Fed is purchasing a lot of bonds, $900 billion on an annual basis, and that the Fed’s balance sheet will continue to expand.

And as the chart above shows, the Fed owns a lot of bonds of various kinds, including Treasuries, TIPS, agencies, and mortgages. Lost in all the noise about tapering is the simple fact that the Federal Reserve does not own a single municipal bond, nor does it purchase municipal bonds. So, when it reduces its purchases of bonds, it will be buying less Treasuries and mortgages, but its plans have no direct impact on the supply and demand for municipal securities. If the law of supply and demand holds true, we can say that, all else being held equal, tapering means fewer buyers of Treasuries and mortgages relative to municipal bonds. In this straight forward supply and demand model, we would expect municipals to outperform Treasuries and mortgages, and for municipal ratios to richen vs. taxable bonds.

As the ratio charts below for various maturities shows, though intermediate maturity municipal ratios have richened recently, shorter and longer maturity ratios are still very cheap.

We would also argue that a form of
tapering has already occurred without undue attention from the market.

Since April, when the first taper tantrum began, retail bond investors have steadily withdrawn money from both taxable and municipal bond funds. Interestingly, the average monthly withdrawal has been about $16 billion, or about 60% more than the size of the announced Fed tapering. Importantly, retail investors selling bonds is very different from a large investor (a.k.a. the Fed) simply buying less bonds.

From a municipal market perspective, we can say that municipal bond prices did not benefit from any Fed purchases to cushion the fall in bond prices as retail investors sold their fund shares. In that regard, tapering has no impact on the supply and demand characteristics of the municipal market as the Fed reduces its purchases. The larger question is, will the taxable market sell off in a tapering environment, and how will municipals respond? Or, is tapering already priced in the market?

If the markets are going to be increasingly reliant on the law of supply and demand in a tapering world, and less on the Fed, perhaps these basic principles, grounded in the thinking of Adam Smith, can offer us some guidance.

The supply of taxable securities has risen dramatically in recent years. This has largely been driven by a surge in Treasury issuance, but a recent jump in corporate bond supply has also helped to increase the size of this market. The municipal market, in contrast, has actually been shrinking. When we look at the ratio of the size of the municipal bond market relative to the taxable bond market, it is at its lowest level in years. Yet, as the ratio charts we examined earlier show, longer term municipal yield ratios relative to Treasuries remain at historically high levels. While many market participants have pointed to longer term municipal credit concerns as a contributing factor to elevated municipal/Treasury yield ratios, we need to acknowledge that the Fed’s open market purchases of bonds have no doubt contributed to this market distortion as well. As a result, it seems reasonable to conclude that municipals have the potential to outperform taxables in a tapering environment.

An important factor that will influence the relative performance of municipals vs. taxables, and the overall total return of the sector, will be the future behavior of retail investors.

Municipal bond prices are driven by the behavior of retail investors and in 2013 their asset allocation has become dramatically unbalanced. If we adopt a simple model that assumes retail investors in aggregate entered the year with a 60/40 blend of stocks and bonds, we can model how their asset allocation has shifted as a result of equity and bond market performance, and their own reallocation throughout the year, which we can model using Investment Company Institute data. The pie to the right shows the current model asset allocation based on this analysis and it highlights an important conclusion: If retail investors rebalance and move their asset allocation back to a 60/40 strategic normal, they will be selling stocks, and buying municipal bonds. Given that retail investors typically
review their investments with their advisors in the first quarter, it would not be a surprise if the months immediately ahead were more friendly to municipals on a relative performance basis. Perhaps bond valuations warrant such a shift. For a long time, many investors have waited for real interest rates on 10 Year Treasuries to approach the historical average of 2%. Now that the 10 Year is yielding about 2.9% and given that inflation has fallen to a 1.2% annual rate, the bond market is, by that one measure, approaching fair value. This too will likely be given consideration by retail investors in the weeks ahead.

 

Jonathan Lewis

Managing Principal

Chief Investment Officer

 

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 which we believe to be reliable, but Samson cannot guarantee the veracity of the information.