Things to Remember, Things to Do in Tough Markets
with Tom Dalpiaz, Managing Director (October 6, 2014)
Was September a harbinger of municipal bond market behavior in some future rising rate environment? Ten-year Treasury bond yields shot up a sizable 28 basis points (or nearly 12%) in the first two weeks of September, the largest and fastest rise in rates so far this year. For munis in the same period, the rise in rates was more muted as high grade ten-year muni bond yields rose just 15 basis points or about 7%. What made this comparatively restrained rate rise for munis interesting was that it occurred in a month when muni bond supply increased slightly compared to year ago levels. New muni deals that came to market in September were well-received, generally oversubscribed, and often re-priced at lower yields. This was a testament to the resilient demand for munis and ongoing challenge of finding attractive paper.
October and November in the muni market typically tend to be months where more new deals come to market. As supply rises, pressure is put on bond prices and yields have a tendency to rise. It remains to be seen if the muni market will experience that additional supply this Fall. Even if that higher volume materializes, it seems likely that the demand for munis will be strong enough to absorb those deals without much incident.
The overall lower supply of municipal bonds has been a persistent force for some time now and it is unclear just when a meaningful and steady amount of new issuance will come back into the market. Even with generally low rates, fewer refundings have been taking place. New money bond issuance has also been modest as many issuers have held off on new deals to help shore up their balance sheets. The sizable need for infrastructure improvements nationwide has been well-documented and the financing required to do those projects will have to come eventually. The first quarter of next year perhaps? We don’t know but we would not count on dramatically rising muni yields or underestimate investors’ persistent appetite for munis and for scooping up whatever volume happens to materialize.
In many ways, the muni market has been tough this year for investors and managers seeking to put money to work. Rates have been fairly low and generally falling, supply has been modest, and spreads have tightened. And then there has been the constant bogey man of “rising rates right around corner”. Even in these tough conditions, we don’t recommend sitting on the sidelines. Important investment jobs still need to get done and we can only work with the markets that are given to us. In tough markets, there are still things to keep in mind and things to do.
For munis, a good place to begin is to remember the simple math that shows the advantage muni bonds can provide for investors comparing after-tax yields among conservative investment choices. Compared to ten-year Treasuries after taxes, double A and single A-rated muni bonds currently provide yield advantages of at least 53 to 126 basis points for investors subject to tax brackets of 25% and above. This could be a good market to get an attractive bid on very short maturity, high quality paper and swap into somewhat longer, single A or carefully researched Baa-rated paper to enhance portfolio yield. To the extent spreads have tightened, it may be possible to take advantage of a strong market and move out of lower quality “troubled” credits if improving credit quality is a goal. Some very long maturity bonds purchased earlier this year likely have gains and could be swapped if shortening duration is desired. Specific portfolio moves of course depend on the particular risk tolerances and investment goals each client has set for their muni money.
Even in tough markets, the everyday search for attractive paper in the muni market continues regardless of how many rocks have to be turned over to uncover value. Whatever the degree of difficulty in the markets, there are always things to do to move forward in the long journey that is bond investing.
Munis By The Numbers
(Sources: Bloomberg, Barclays Capital)
When does 2.45% = 4.32%? When you are an individual investor subject to the top Federal income tax brackets and you capture a 2.45% yield from tax-exempt municipal bonds.
The 2.45% 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: 90% (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: 137% (compared to an average ratio of 125% for the past ten years).
Moving from cash to 5-year munis: +115 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: +234 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 225 basis points).
-0.01% September total return of the Barclays 3-Year Municipal Bond Index (+1.34% YTD, +1.33% for all of 2013)
-0.05% September total return of the Barclays 5-Year Municipal Bond Index (+3.10% YTD, +0.81% for all of 2013)
-0.13% September total return of the Barclays 7-Year Municipal Bond Index (+5.23% YTD, -0.97% for all of 2013)
-0.09% September total return of the Barclays 10-Year Municipal Bond Index (+7.24% YTD, -2.17% for all of 2013)
+0.32% September total return of the Barclays Long Municipal Bond Index (+12.73% 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.