Detroit declares bankruptcy!
The Federal Reserve to taper!
Investors bail on muni funds!
Puerto Rico – the next Detroit!
What to expect from these headlines? For individual municipal bond investors, the answer is easy: Great yields on high-quality municipal bonds!
Reality belies headlines
As experienced bond investors, we dig deeper than the headlines and talking heads. What we see behind events that have rattled the muni market recently reveals the problem is, once again, about perception, not fundamentals.
Take the Fed, for example. In early May, Chairman Ben Bernanke hinted the Fed may start to unwind its “quantitative easing” strategy. In a span of about two months, in a typical knee-jerk reaction, institutions sold Treasuries. Yields on 10-year Treasury bonds rose almost a full percentage point.
The financial media fell in love with the term “interest rate spike.” Pundits, heralding a “rising interest rate environment,” implored investors to sell their bonds. True to form, they failed to distinguish between Treasuries, tax-free bonds and all other fixed-income investments. Lost in the hysteria was any sense of relativity as taxable Treasuries still yield less than 2.9%. (We are compelled, again, to mention that we don’t know any individual investor who owns 10- year Treasury bonds.)
Mutual fund shareholders then got into the act, scrambling en masse to exit their bond funds. Struggling to meet the overwhelming redemption requests, the funds were forced to dump enormous quantities of municipal bonds on the market.
Subsequently, fund prices dropped, precipitating even more panic selling. Municipal bond yields skyrocketed, dwarfing the increase in Treasuries.
This dynamic has persisted for 15 straight weeks as bond funds flooded the market with more than $24 billion of tax-free bonds. In direct contrast, traditional muni investors, who buy individual tax-free bonds, bought more munis than they sold by a ratio of better than 2.5 to 1.
No surprise
Although it made for sensational headlines, the Detroit bankruptcy should have come as no surprise to anyone. The city had been deteriorating for more than a decade, experiencing numerous credit downgrades along the way. The Detroit situation, however, practically fostered a cottage industry of journalists and others predicting the next city to face a similar plight. The fact that municipal bond defaults are extremely rare seems to have been lost in the discussion.
In fact, fiscal clouds are receding. State tax receipts are up, and government spending is down. State tax receipts have risen 8.6% in the first quarter of the year vs. the same period last year, according to the Nelson A. Rockefeller Institute of Government. It was the 13th straight quarterly increase.
A longer view
If we were new to the business, we would say that investor panic attendant to headlines predicting every kind of disaster for Puerto Rico, other than being swallowed up by the ocean, was unprecedented. But it wasn’t long ago we spent hours responding to hundreds of investors from California asking if they should sell all their California bonds as burgeoning budget deficits had the media labeling the state the next Greece.
To the contrary, we explained how the state’s debt was structured and we encouraged investors to take advantage of the higher yields made available, courtesy of media sensationalism. Today, these fears have faded and California is being lauded for its fiscal responsibility.
And what bond investor will forget the “60 Minutes” interview with a certain doyenne of doom that created another baseless round of muni bond selling (“Thanks, Meredith“) as well as tremendous opportunities for bond buyers to enhance their tax-free income.
Now comes Puerto Rico
In an even more severe manner, Puerto Rico bond prices have been battered by similar panic selling, but as we have said in our Bond Forum, we see no likelihood of imminent default by any Puerto Rico issuing agency. We anticipate a rocky and somewhat uncomfortable ride for bondholders, but as fiscal reforms are implemented, we expect all principal and interest to be paid on a timely basis.
It’s axiomatic that all investments have a certain degree of risk and we are aware that potential perils remain in the economy and in certain states and cities. But today, muni investors searching for value don’t have to look very far.
High quality tax-exempt bonds can be purchased today to yield more than 5.00%. This is equivalent to more than 8.00% on a taxable bond for investors in the top federal tax bracket – and that’s not including the Medicare surcharge.
We have no doubt, at some point, the fund outflows we discussed previously will become inflows and strong institutional demand will return to the market.
Meantime, we are pleased to see statistics show that individual bond investors are not only ignoring the hype, they are keeping their eye on the ball and taking advantage of today’s unusual opportunities.