Rumblings unlikely to shake muni bond fundamentals
September 06, 2013
A signal that the Federal Reserve could start "tapering" its bond purchases sent jitters into the market and precipitated interest rate changes that led to this summer's broad sell-off across the fixed income sphere. Municipal bonds were not immune to the activity, particularly in light of the recent decision by Detroit authorities to seek bankruptcy protection.
To gain insight into developments in the muni market, we spoke with Vanguard's head of municipal bond operations, Chris Alwine.
Why did munis get hit so hard?
There are a few reasons munis took it on the chin—and, really, it was a confluence of factors, some relating to interest rate risk and some due to the perception of heightened credit risk in the asset class after the Detroit bankruptcy filing. To understand the reasons is to understand the makeup of the market itself. The pressure on muni prices was magnified because of the illiquid nature of trading in the muni market.
What would you tell clients who may have been surprised by the recent volatility?
With individual investors holding a large share of the municipal market, the muni investor base tends to be more homogenous than that of other fixed income sectors. It is generally more conservative and looks to munis for capital preservation, tax-exempt income, and as a portfolio stabilizer and diversifier.
Interest rate risk, perceived credit risk, and market illiquidity took a hit on munis.
Munis are attractive on a historical valuation basis, but they could still face headwinds from Fed tapering, debt-ceiling debates, and "headline risk."
Despite rumblings in the muni market, investors should tune out short-term noise and maintain balance, diversification, and a long-term perspective.
This homogeneity makes the muni market more prone to short-run volatility. Because of the thinner muni market liquidity and the tendency for trading to lean in one direction, individuals reacting to headlines or short-term price movements can create imbalances in the market that cause munis to overshoot to cheap or rich levels on a relatively short-term basis. This is one reason we recommend to our clients that they tune out short-term noise and maintain balance, diversification, and a long-term perspective when investing.
Does that mean muni bonds are oversold and undervalued?
I'd say that munis are cheap on a historical valuation basis relative to other segments of the fixed income market. This is especially true on a tax-equivalent yield basis for investors in high-income tax brackets. They have also become more attractive to investors lower on the tax ladder.
As munis sold off over the summer, their prices declined more than those of Treasuries, such that the yield of 10-year municipals stood at 103% of that of 10-year Treasuries in late August, above the historical 10-year average ratio of 96%.
But I'd qualify that the lower muni prices provide a cushion for investors. Historical valuations are but one of many factors to take into consideration. At the same time, there's also potential for more volatility from Fed tapering, debt-ceiling debates, and headline risk from Detroit's bankruptcy proceedings.
Some are calling the Detroit bankruptcy filing a game changer for the muni market. Do you agree?
I said earlier that the municipal bond investor tends to be fairly homogenous. But the market itself—the securities—is heterogeneous and, therefore, should not be brushed with broad strokes. There is roughly $3.7 trillion in assets with more than 95,000 issuers. A majority of the market is high-quality, AA-rated, with only a small percentage of the universe rated below investment grade.
The fiscal mismanagement that led to Detroit's bankruptcy filing did not happen overnight. To underscore that point, Detroit's credit first fell below investment grade in 1992. Bankruptcy filings are typically predictable because these entities have been in trouble for some time. So to answer the question, no, I don't think Detroit was a game changer.
Is there concern that bankruptcies like Detroit's will become more common?
If history is any gauge, we don't believe so. According to Moody's, the one-year default rate averaged 0.03% for Moody's-rated municipal issuers over the past five years, which includes the last recession. There is the potential that filings could increase more than in the past, but we think the risk of a substantial increase in bankruptcy filings remains very low.
What do you think is the best way for clients to minimize risk in munis?
The complexities of the recent credit events serve as a reminder to the breadth of expertise required to dissect and analyze various facets of muni bonds. In-depth professional credit research is key to investing in munis. Additionally, broad diversification across issues helps to minimize exposure to a singular credit event.
So you believe munis can still play a role in a client's portfolio?
Definitely. Muni bonds remain an attractive long-term investment despite the headwinds we've been facing. Even with rising rates, munis play an important diversifying role in a long-term asset allocation strategy. In our view, muni bonds are attractive compared with taxable bonds on a tax-equivalent yield basis. Also, muni yields have historically been less sensitive to rising rates than Treasuries, adding a stabilizing dimension to an investment portfolio.
- All investing is subject to risk, including the possible loss of the money you invest.
- Past performance is not a guarantee of future results.
- The performance of an index is not an exact representation of any particular investment as you cannot invest directly in an index.
- In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
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