Municipal Watch: Uncertainty brushes munis
The municipal bond market hasn’t been immune from the rising-yield environment spawned by all the uncertainty surrounding when and by how much the Federal Reserve will begin pulling back on quantitative easing. Yields on 5-year, 10-year and 30-year AAA-rated muni bonds have risen 26, 44 and 50 basis points, respectively, since April 30. This may be welcomed by yield-seeking investors, but the run-up has come at a cost of price depreciation.
The good news on that latter point is that muni bonds are faring better in this rising-yield environment relative to taxable investment-grade corporate and Treasury bonds. The key reason for this outperformance recently has been that large portions of the universe of long-term muni bonds are callable and are currently priced at large premiums to par with coupons well above current market yields. Thus, these premium bonds currently trade to their call dates (typically 10 years and shorter) rather than their maturity dates, resulting in a shorter duration. So long as market yields don’t spike hundreds of basis points, this callable feature offers a defensive tool for muni portfolio managers to shorten duration relative to lower coupon bonds pricing to maturity.
Despite the layers of uncertainty over what the Fed will do—policymakers have made clear they won’t start taking away the punch bowl until the underlying economy is strong enough not just to stand on its own but to generate much more robust employment growth without accompanying inflation, characteristics that remain very much uncertain—the muni market continues to function relatively well. State and local finances continue to improve. Default rates continue to be very low. And muni yields continue to trade relatively close to comparable Treasury yields (generally in the 90% to 100% range), positioning munis for potential outperformance. There are potential outlying risks, most notably a possible limit on munis’ tax-exempt status (the Obama budget seeks to cap tax exemptions at 28%). But that’s an issue for down the road. For now, munis are holding up relatively well amid all the uncertainty.