The Good
After the bond market sell-off in June and July, which saw unprecedented bond redemptions, it's the intermediate- and longer-maturity bond yields that are the most attractive they've been in years. Even after some improvement in the market since September, there are plenty of 3%+ ten-year, 4%+ fifteen-year and 5%+ twenty- to thirty-year tax-free yields. All but the highest of municipal credits in these ranges are trading higher than corresponding US Treasury yields. At the same time that yields have spurted up over 100 basis points (1%), inflation has been declining. Trailing headline inflation, which had been at 2% at the end of February, is now at 1%. The math is simple: yields up over 1%, inflation down 1%. This is the cheapest that tax-free bonds have been on a REAL basis in quite some time. Locking in SOME book yields that are so high relative to current inflation is prudent.
And though Detroit and Puerto Rico have grabbed most of the credit headlines, the real story on municipal credit is that most municipalities are in the best shape they have been since the financial crisis, and in many cases they are better off than they were before the crisis. Most municipalities have undergone dramatic belt-tightening in the past five years. But the austerity has paid off. This should mark the 16th consecutive quarter of RISING overall municipal receipts. And there has been progress on the pension and other post-employment benefits (OPEB) front, even in states with the biggest problems, like Illinois. For the first time since the financial crisis, municipalities are NET hirers of workers this year.
The Bad
In our opinion, the panicked reaction of bond fund investors to the notion of Fed tapering was dramatic and greatly exaggerated. There was nothing orderly about the backup. Yields climbed on intermediate- and longer-term municipal bonds at an INCREASING rate during June/July. This trend was further compounded by an almost complete lack of support by Wall Street firms during the worst part of the meltdown (which, of course, helped CREATE the meltdown). For all purposes, it is as if the retail holders of bond funds mistook TAPERING (buying fewer bonds on a monthly basis by the Federal Reserve) with SELLING. Outright selling by the Fed could be years off. And with the federal deficit falling rapidly, the need to ISSUE Treasuries could be quite small. Right now it seems reasonable to conclude that that the FEAR of tapering is much worse than TAPERING itself will turn out to be. Bond fund flows have continued to be negative – though not nearly at the pace of June and July.
The Ugly
Detroit and Puerto Rico have been the poster children this year for failure to address fiscal problems.
In the case of Detroit, the bankruptcy (filed in July and upheld this month) marked the culmination of years of downward spiraling. In a city that saw its bustling population of 1,800,000 some thirty-five years ago dwindle to an anemic 750,000 today, a steadily declining workforce found itself shouldering the pensions and benefits of an ever-increasing group of retiring workers. This unworkable equation meant that it was only a matter of time before the city’s budgets buckled into fiscal collapse.
In the case of Puerto Rico, there is concern about whether the Commonwealth will be able to access the debt markets going forward. Puerto Rico has actually made real progress in cutting its deficit and addressing its pension issues. The cover of an August issue of Barron’s, highlighting Puerto Rico’s financial woes, points out how headline risk can rapidly escalate market risk. Puerto Rico’s financial problems have been well-known for some time. What the Barron’s story pointed out was the fact that many municipal bond funds held 20-30% of their assets in Puerto Rico paper because of its exemption from income taxes in all fifty states. This "revelation" begat fierce selling of Puerto Rico paper, and the market quickly backed up over 200 basis points (2%) on many issues. While Federal officials have been meeting with Puerto Rico officials to see if an enhanced level of cooperation can help to ease the financial crisis, the outcome on Puerto Rico is still up in the air. The Puerto Rico fiasco points out the need for as much vigilance with regard to headline risk as for outright financial risk itself.
So as we head into 2014, our viewpoint is that – away from the problem areas – intermediate and longer tax-free municipal bonds offer the best values they have in a long time. We feel the combination of now-higher interest rates, lower inflation, and better overall municipal credit affords investors a very good bargain for the assumed risk.
Happy Holidays.
John Mousseau, CFA, Executive Vice President & Director of Fixed Income