The Muni Bounce Back

After what can only be described as a miserable summer for the municipal bond market, the muni market came back to life in the second part of September. Really cheap blocks of 5%+ yields became harder to find as the last week of September rolled through, and the countless bid-wanted lists from the municipal bond funds (whose redemptions started the ugliness back in June) actually began to get good bids, as well as deeper bidding. We have seen yield curves cut in the second half of September and particularly in the last few days of the month.

What happened?

1. Bond-fund redemptions slowed down. After essentially flat flows in April and May, the muni market got hit with the sledgehammer of $16 billion in redemptions in June, followed by $13 billion in July. August saw another $8 billion. We don’t know the final tally for September yet, but it seems to be much smaller. The hemorrhaging started with a market that scared itself into higher yields and then cratered the muni market as retail investors became panicked sellers of funds when fear of Fed tapering took hold. Yields went high enough that fund redemptions started to be offset by sales. Investors looked at the higher yields and the lower net-asset values of the funds and decided that the horse had left the barn and there was no need for additional selling.

2. Crossover buyers entered the arena. We have written about this phenomenon before. These are traditionally taxable bond buyers –foreign buyers, foundations, life insurance companies, pensions, etc. – who realized that the tax-free muni bond yield had reached levels that were higher than corporate yields or, in some cases, higher than the yields on the TAXABLE municipal bond from the same issuer. If this phenomenon sounds absurd, it is. And crossover buyers finally grabbed onto it.

3. Detroit and Puerto Rico – whose credit issues caused an overhang on the muni market that probably delayed its recovery – have been in the news long enough that the market has adjusted to them. Detroit will clearly be worked out in the courts. Vendors, pensioners, and bond owners were all asked to take a haircut on what is owed them; and, not surprisingly, no one wants to. Puerto Rico, which is grappling with its own economic challenges and pension issues, saw its bonds cheapen dramatically this summer, in our opinion because of the fear that all the fund families that own large amounts of Puerto Rico paper (which is double-exempt in all 50 states and therefore owned in large percentages by single-state muni funds) would head for the exits at the same time. It appears that this flight is not transpiring; there has been some recovery in the price of Puerto Rico paper in September.

4. The individual buyer has been taking advantage of 5% yields. The taxable-equivalent yield of nearly 9% or even higher (when state taxes are included) began to attract inflows to the market. There is no question that there was some rotation out of bonds and into equities last fall. With the advance of the stock market, there is some evidence that some of this flow is being reversed. Last November we had a ten-year US Treasury bond at 1.7% and many blue-chip stocks yielding nearly 2.5%. To a large extent, that has been reversed.

What didn’t happen?

1. Wall Street liquidity: it was terrible. Firms that bring deals to market were nowhere to be seen when the bid-wanteds from bond funds started to explode with redemptions in June. There were many days when Cumberland was bidding on blocks of longer-maturity bonds of WELL KNOWN issuers, and we were the only bidder. In many cases we did not end up buying because of the paucity of bids (and of course we were bidding cheap, as we didn’t see any support from the Wall Street firms). In our opinion, the amount of capital devoted to the muni market needs to be increased by Wall Street firms.

2. Tapering. The bond market – both Treasuries and tax-free bonds – priced what would normally be a year and a half of rising yields into four months. In the case of munis, it was two years worth of rising yields. The unclear language of the Federal Reserve clearly exacerbated things, but the market clearly took tapering (buying ASSETS but LESS of them) to mean SELLING. At its last meeting, the Federal Reserve decided to hold off for now. All of our work suggests that the FEAR of the event is worse than the event.

3. Inflation: Inflation, reflected in many different measures, has FALLEN since the end of last year, while the Fed would clearly like to see it rise. So with interest rates another 150 basis points higher in the muni market and inflation lower, real AFTER-TAX yield reached its highest levels in many years. And it reached them in a matter of months. In our opinion, it is impossible to achieve a longer term, higher level of interest rates WITHOUT sustained higher inflation. And we do not have it.

4. Growth: Increases in real GDP have dwindled, not strengthened, since the end of last year and the start of the Federal Reserve’s latest quantitative easing. Other periods since World War II which have seen higher interest rates combined with FALLING inflation and FALLING real GDP growth have usually seen a slowdown. At a minimum, those periods have eventually resulted in lower interest rates.

At Cumberland we have recognized this ugly summer for bonds to be one of opportunity. We have been extending durations of bond portfolios, recognizing that the juxtaposition of a 5% high-grade tax-free bond with a 3.75% US Treasury bond is not an opportunity that will last forever. We have been bidding on cheaper, lower coupon bonds issued last year and earlier this year, which now trade at significant discounts; and we have been trying to buy new issues coming to market in the 5% range.

It was a long summer. We know that autumn is bringing cooler weather. We also believe it is bringing a better bond market.

BY John Mousseau