Municipal Bond Market Outlook
R.J. Gallo, senior portfolio manager and head of Federated's municipal bond investment group, offers his perspective on the municipal bond market.
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Municipal Bond Market Outlook: More Calm Than Crisis
The municipal bond market has seen falling prices in the fourth quarter of 2011. What's been driving prices down? Is the Harrisburg, Pennsylvania, bankruptcy filing the latest sign that a municipal credit crisis that some had speculated about earlier is starting to play out? And is the tax-free status of municipal bonds (munis) in jeopardy? Senior portfolio manager R.J. Gallo, who oversees Federated's municipal bond investment group, discusses the outlook for municipal bond markets.
What factors have affected municipal bond prices and yields?
At the start of the fourth quarter in 2011, we have seen municipal bond prices head lower, driven by the basic forces of supply and demand. As we neared the end of the third quarter 2011, issuers were looking at attractively low borrowing costs and multigenerational lows in municipal yields – levels around 1% for a five-year muni, around 2.2% for a 10-year AAA muni and about 3.5% for a 30-year muni. It is important to note that this is a normal process: Supply and demand will drive prices in any environment. Though the demand has been relatively stable, the surge in supply explains the change in prices. There haven't been other factors, such as a surge in credit concerns, that might get people worried.
Should municipal investors be concerned about defaults?
The concerns about the muni credit crisis drove a sharp correction in muni bond prices in the fourth quarter of last year, so it remained very much on people's minds. Europe now seems to have pushed municipals off the front page. As for the recent news in Harrisburg, Pa., we don't think it's the beginning of a series of municipal bond defaults across the country. The analysts who had predicted that 2011 would be a bloodbath in muni credit were looking at significant challenges: falling property values, decreasing real estate tax revenues and cuts in state aid to local governments. Those are all significant challenges, but they did not produce a wave of bankruptcies. Instead, we've seen local officials, in large, take reasonable actions by cutting expenditures, reducing workforces, forgoing projects and, in some cases, raising taxes. They have been balancing their books in a difficult time, rather than rushing off to court to file Chapter 9 bankruptcy.
Is the tax-free status of municipals in jeopardy?
The tax-free status of munis has been talked about rather frequently in the halls of Washington in the last year. The fact of the matter is that tax-exemption tends to benefit individuals who are in the top 2 or 3 marginal tax brackets. And, when Washington has a lot of red ink, they look for money under a lot of rocks. So eliminating municipal exemption is one option that has come up. The Congressional Budget Office last year made a proposal that the elimination of tax-exempt municipal issuance going forward would raise significant sums for the Federal Treasury. Chances are we're not going to see a change in the tax code that would prompt a sharp decline in existing municipal securities, but there might be some limitations on who can issue tax-exempt bonds in the future. Or perhaps in the extreme, we could see some change in the issuance of tax-exempt bonds of any sort in the future. But, these proposals remain relatively unknown, and they're still being discussed in the halls of Washington.