What Could Go Wrong... And Right for Munis in 2015
with Tom Dalpiaz, Managing Director (January 6, 2015)
“It’s tough to make predictions, especially about the future.”
We’ve seen this quote in various forms and attributed to an eclectic group of people including Yogi Berra, Sam Goldwyn, Mark Twain, and Niels Bohr, a Nobel Prize winning physicist. Regardless of its origin, we believe it’s the perfect tongue-in-cheek warning as we find ourselves deep into the season of financial market prognostications. We understand the natural desire for investors at this time of the year to get a fresh sense of where markets are headed and we are happy to offer our views. As seasoned market observers, we do so with humility and the knowledge that random events and unforeseen consequences can confound the most carefully reasoned scenarios.
Given the muni market’s impressive total returns in 2014 and our inherent bond manager DNA, it seems natural for us to assess the muni market’s prospects in 2015 by asking what could go wrong for munis. Along the way, we might discover what could go right for munis as well. In fact, as we walk ourselves through various “what-could-go-wrong” possibilities, we conclude that worst case scenarios are unlikely to materialize and that 2015 is likely to be a reasonable and workable year for intermediate muni bonds.
What could go wrong?
- Treasury yields could rise from current low levels. A rise in Treasury yields tends to pull muni yields along in the same direction. Munis and Treasuries, however, don’t usually move in lock-step and we expect muni specific factors in 2015 to dull the impact of rising Treasury yields to some degree (see reasons below). The forces currently working to push rates higher are evident: a U.S. economy demonstrating meaningful growth, an improving labor market with consistently strong growth in payroll employment, and a declining unemployment rate not too far away from some estimates of full employment. The Federal Reserve’s uncommonly easy monetary policy has been in effect for an extended period now (over six years) and the Fed itself is projecting a higher Fed Funds rate target likely by the third or fourth quarter of 2015. On the flip side, lower oil and commodity prices are keeping domestic measures of inflation well below the Fed’s target. Anemic economic activity in Europe and Japan will likely feed global deflationary forces and make even 2% 10-year Treasury yields attractive to global investors. Consider also a more slowly growing Chinese economy, global central banks instituting stimulus measures, and more than enough potential international political turmoil to prompt multiple Treasury bond flights-to-quality. With these countervailing forces considered, we suggest the case for sharply rising Treasury yields becomes less persuasive.
- The demand for muni bonds could drop. What might cause this? Lower Federal tax rates, a buyers’ strike (caused by massive “sticker shock” from muni yields being too low), a very large re-allocation from munis to stocks, or detailed Federal tax reform proposals coming out of Congress. In reviewing these forces, we are hard-pressed to believe that any of them are likely to have staying power in 2015. Lower tax rates in 2015 are a non-starter. Sticker shock from low yields has simply not happened given the meager alternatives available to conservative investors. Any rise in rates would lessen the probability of a buyers’ strike. A sizable shift from munis to equities seems unlikely given a stock market prone to valuation concerns every step of the way. While actual, full-blown Federal tax reform is highly unlikely to become law in 2015 or 2016, a detailed proposal could emerge from Congress this year. The proposal alone could stir some fears in the muni market, effect muni bond demand, and push rates temporarily higher. We would see such an event as a buying opportunity.
- The supply of muni bonds could increase. The supply of new issues that came to market in 2014 was less than the volume of muni bonds maturing last year. This has been a recurring theme for the muni market as last year was the fourth in a row where the muni bond market actually shrunk in size. The reduced supply/resilient demand dynamic for the muni market was an important driver of attractive returns in 2014. Most muni market observers are projecting a modest increase in new issue muni bond supply for 2015. Infrastructure needs nationwide are well-documented and a much higher volume of new bond issues was approved by voters in November’s elections. If interest rates stay low for longer than expected this year, refunding issues should add to overall muni bond supply. The credit capacity of most muni issuers has improved steadily in recent years creating conditions for them to take on debt issuance they had postponed. We suggest the additional supply to come in 2015 is unlikely to overwhelm the market, however, as issuers will continue to exercise a degree of caution in order to maintain their hard fought improvements in financial health.
- Muni bonds could experience a credit spread widening. As muni yields have moved lower and credit conditions generally have improved, credit spreads among munis have become fairly tight (Puerto Rico and Detroit being exceptions). If credit spreads were to widen significantly from these levels, single A and BBB rated muni bonds in particular could suffer disproportionately. However, we don’t believe a meaningful credit spread widening across the muni sector is likely in 2015 since we don’t expect a major new credit event or a recession (two of the usual causes of a sector-wide credit spread widening). Ongoing headline risk from the usual suspects in the muni market (Puerto Rico, Illinois, Chicago, and New Jersey) could be a source of consternation and temporarily higher yields for those issuers. A wildcard: if 2015 is the year that Puerto Rico’s re-working of their debt is confined to its electric authority and other Puerto Rico entities fully honor their obligations, then the general perception of creditworthiness for all munis could improve.
Some Bottom Line
A sharp mind can always create an impressive list of things that can go wrong and 2015 will not likely disappoint sharp-minded investors. But as we run through these worries from a muni specific perspective, it is our judgment that munis, particularly intermediate maturities, can weather 2015 in a reasonable fashion. The negative forces that could derail munis seem, in our opinion, unlikely to occur or at least to occur in degrees that are bearable. Treasury yields could go up but we believe countervailing forces slowing that rise are meaningful. None of the things that could diminish demand for munis seem very likely except an actual detailed proposal coming out of Congress on Federal tax reform (we suggest the impact would be temporary). Supply should increase but not to an amount that would overwhelm the resilient muni bond demand that has become something of a marvel. On the credit side, some headline risk from the usual suspects is to be expected but not to the extent of causing pervasive credit spread widening.
A Cautionary Note
And yet, having said all this, we know markets make it a practice to confound the best laid plans. We know a sloppy bond market, whether it is prompted by rational or irrational forces, can deteriorate quickly particularly given liquidity concerns that exist in many of today’s bond markets. This is yet another reason why we believe in intermediate maturity/investment grade municipal bonds as an effective vehicle through a full interest rate cycle for achieving a number of investment goals. By driving in that kind of vehicle, we believe investors already place themselves in a relatively protective position while giving themselves the opportunity to garner attractive tax exempt yields.
Munis By The Numbers
(Sources: Bloomberg, Barclays Capital)
When does 2.53%=4.48%? When you are an individual investor subject to the top Federal income tax brackets and you capture a 2.53% yield from tax-exempt municipal bonds.
The 2.53% yield stated above is our conservative estimate of an average yield to maturity for a muni bond portfolio constructed under present market conditions with the following parameters: all investment grade credits, average credit rating A1/A+, all bonds mature within 15 years, average maturity 5 to 6 years, portfolio duration range 3.5 to 4.5 years.
10-year High Grade Muni bond yields as a percentage of 10-year Treasury bond yields: 97%(compared to an average ratio of 98% for the past ten years).
10-year Single A rated Muni bond yields as a percentage of 10-year Treasury bond yields: 158%(compared to an average ratio of 127% for the past ten years).
Moving from cash to 5-year munis: +132 basis points (Yield difference on tax-exempt money market funds and AA rated tax-exempt muni bonds with a 5 year maturity).
Moving from 2-year munis to 10-year munis: +229 basis points (Yield difference on AA rated 2-year tax-exempt muni bonds and AA rated 10-year tax-exempt municipal bonds. Average spread for the past five years is 224 basis points).
-0.29% December total return of the Barclays 3-Year Municipal Bond Index (+1.51% YTD, +1.22% for all of 2013)
-0.32% December total return of the Barclays 5-Year Municipal Bond Index (+3.19% YTD, +0.81% for all of 2013)
+0.10% December total return of the Barclays 7-Year Municipal Bond Index (+6.09% YTD, -0.97% for all of 2013)
+0.47% December total return of the Barclays 10-Year Municipal Bond Index (+8.72% YTD, -2.17% for all of 2013)
+1.03% December total return of the Barclays Long Municipal Bond Index (+15.39% YTD, -6.00% for all of 2013)
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The opinions expressed are those of the Granite Springs Asset Management LLC Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. This material is for educational purposes only. Granite Springs Asset Management LLC is an investment adviser registered with the US Securities and Exchange. Registration does not imply a certain level of skill or training. More information about Granite Springs Asset Management LLC can be found in its Form ADV which is available upon request.