The next time a news headline of a potential credit concern arises for a city, state or county, step back from the fray and take a look at a map of the United States. Then envision 50,000 pushpins nestled within the country’s boundaries, including one topped by a pulsing red light.
Against the widely varied landscape of the U.S. municipal bond market, such a miniscule beacon illustrates the small portion of the overall market that potential default represents. The municipal bond market – which encompasses debt issued by states, counties, cities and any number of entities within those bodies, from schools to sanitation districts – consists of 1.5 million issues sold by 50,000 municipal issuers worth an estimated $2.9 trillion. By comparison, there are approximately 6,500 stocks in the Wilshire 5000 Total Market Index, the broadest measure of the U.S. equity market.
“The municipal market can act inefficiently, reacting to dreary headlines with broad generalizations that can create relative value opportunities. But there can be a silver lining to the negative tone,” says Timothy McGregor, director of municipal fixed income management with Northern Trust Global Investments. “At times, municipal bonds yield more than they fundamentally should. Investors can get a better tax-free income flow.”
A History of Security
The interest paid on municipal bonds is mostly free from federal income taxes and can provide tax benefits on the state and local levels. Such preferential treatment is occasionally questioned by legislators and other policymakers, more frequently amid tax overhaul debates. “It’s a wild card,” says Bob Browne, Northern Trust’s chief investment officer. “Are changes possible? Certainly, especially if tax reforms happen. It’s not something we’re focusing on, but we’re not ignoring it either.”
Along with the tax advantages, municipal bond investors have long relished the relative stability of such investments. To that end, ratings firm Moody’s Investors Services reported just 54 defaults occurred on investment-grade municipal bond issues between 1970 and 2009. Furthermore, the value of defaulted municipal bond debt totaled $8.2 billion in 2008, $7.3 billion in 2009 and $2.7 billion in 2010, according to the Distressed Debt Securities Newsletter.
Of course, historical data has no predictive value, and deteriorating conditions around the United States could certainly lead to greater volumes of defaults in the future. Still, municipal bond issuers have a lengthy history of meeting obligations, and as a portion of state and local government budgets, interest payments are relatively small – 5.3% of state and local revenues in 2008, according to the U.S. Bureau of Economic Analysis.
“Municipal debt obligations are a very modest portion of most budgets for the issuers Northern Trust [recommends for its clients],” McGregor says. “We do not expect that their bond payments are likely to lead these issuers into financial difficulty.”
Rocky Times for Municipal Bonds
While hindsight tends to smooth historical market perspectives, turbulence can and will occasionally jostle the municipal bond market, especially in the next couple of years, Browne says.
“While our fixed-income philosophy focuses on income and a high probability of capital preservation, that doesn’t mean there’s no risk in fixed income,” he says. “We absolutely believe we will see higher volatility for bonds overall and municipal bonds in particular.”
At the core of this cautionary outlook is the expectation that interest rates on most bonds will likely continue to climb in the coming quarters as the U.S. economy improves and investors move from fixed-income investments to riskier assets. Other potential catalysts for higher rates include budgetary woes at state and local levels, rate hikes from the U.S. Federal Reserve, greater economic expectations and inflationary pressures, which could blossom in a bustling economy.
“Municipal bonds are far from perfectly correlated with Treasuries, but they do tend to go in the same direction,” McGregor says. “We expect volatility to continue through 2011.”
This year got off to a rough start in the aftermath of a tumultuous fourth quarter of 2010. During this time, interest rates increased, an overabundance of supply flooded the municipal bond market, high-profile analysts fanned default fears and massive mutual fund redemptions stoked heavy selling pressure. Moreover, brokers and dealers, who historically served as a backstop to the municipal market by absorbing excess supply, balked at adding large volumes of the securities.
“A reduction in risk tolerance and in capital by the municipal broker dealer community is an ongoing theme that keeps volatility high and increases the potential for greater-than-normal price movements in both directions,” McGregor says. “Supply and demand are larger factors in this environment of risk reduction.”
A significant contributor to the municipal bond market’s broad slump in 2010 stemmed from the expiration of the Build America Bonds (BAB) program. Passed as part of the 2009 American Recovery and Reinvestment Act, BAB offered a 35% subsidy from the federal government – in the form of direct payments or tax credits – on interest paid to bondholders.
When Republicans won control of the House of Representatives in November 2010, the likelihood of the program being extended diminished greatly. As a result, many states and municipalities rushed new issues to market before the program’s December 31, 2010 expiration date.
“The BAB program was a very successful alternative source of about $200 billion of financing for municipal issuers. It was particularly valuable for long-term issues and lower-rated issuers,” McGregor says. “While a modified version of BAB may reappear in 2011, we believe that is unlikely unless the economy takes a sharp turn for the worse.”
Discipline and Insight Remain Essential
The municipal bond market stands as the last bastion for individual investors, who own about two-thirds of all municipal bond issues. And while higher yields can attract nontraditional municipal bond investors – hedge funds, corporations and other entities that don’t benefit from the tax advantages – the market’s momentum swings will likely continue to reflect the psyche of individual investors.
To protect yourself from potentially irrational highs and lows, vigilance pays. A thorough credit analysis of any bond relies on extensive data and information supplied by the issuer of the security. And while inconsistent disclosure practices have undermined the municipal bond market for years, the need for disclosure standards has recently drawn increased interest, says Colin Robertson, managing director of fixed income at Northern Trust. In the future, he’s confident that Congress and regulators will continue to address the need for reporting regulations.
In short, know what you hold, know why you hold it and understand how it fits within your broader investment plan.
“A growing number of investors want to learn more about municipal bond portfolios, and that’s a very good thing,” McGregor says. “It’s comforting to see investors move up the learning curve and understand what they want to own and why.”
This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Corporation, and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor’s particular objectives, risk tolerance, investment horizon, tax status or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy can not be guaranteed.