There is something strange going on in the Municipal Bond Market and it may well be another opportunity for resourceful investors to buy tax advantaged cash flows at attractive prices. There has been a selloff over the past two weeks and as prices decline, yields get more attractive.
- A confluence of events seems to have sparked a selloff in the municipal bond markets.
o Treasury yields rose, which led some investors to want to sell as treasury prices went down.
o A massive amount of municipal bond supply came into the market, about $39 billion for the period November 1st through November 19th.
o A changing of the political guard makes the anticipated tax hikes slightly less certain, which takes the focus off tax advantaged municipal bonds.
o The municipal bond market is more inefficient and fragmented now than it was prior to the 2008. The financial crisis and the collapse of both municipal bond insurers and bond credit rating agencies have affected the muni-market.
- If you can buy a 10 year AA rated, essential services revenue municipal bond with a yield of 4%, your taxable equivalent yield for someone in the 35% Federal Income tax bracket would be 6.15% (if state taxes are zero), or 6.80% for a California resident paying the maximum CA state tax rate.
US Muni General Obligation A+ (Orange) yield curve 11/26/2010 (left) and 10/26/2010 (right)
- To put a taxable equivalent yield of 6.15% to 6.80% into perspective, the annualized return for the S&P 500 US equity index over the last 15 years (10/31/1995 to 10/29/2010), has been 6.74% before taxes (source Bloomberg).
- There are dangers that need to avoided in the municipal bond market.
o Indirect investment vehicles, ETF’s, mutual funds and closed end bond funds will most likely have more severe price reactions to changes in yields and interest rates.
o According to a Wall Street Journal article on 11/26/2010, “Investors pulled an estimated $4.78 billion out of municipal bond mutual funds last week.”
o Indirect investment vehicles do not offer investors the opportunity to hold to maturity and realize a fixed yield to maturity.
o The mob mentality that contributes to these massive inflows and outflows to pooled investment vehicles can create opportunities for individual bond buyers
o According to a Wall Street Journal article on 11/26/2010, “Retail or individual, investors hold an estimated two-thirds of outstanding bonds in the $2.8 trillion muni market, through individual accounts and mutual funds. The rest are held by large institutional investors.”
- Building a portfolio of individually selected municipal bonds, provide investors with attributes not available in pooled (indirect) investment vehicles.
1. Return of Principal at maturity – Safety
2. Contractual Cash flow payments – Federal Tax Free Income
3. A known return or yield to maturity, if held to maturity – the ability to ride out market fluctuations with the confidence that you are earning a return and that your investment principal is highly likely to come back to you.
We are not overly worried about the safety of the Municipal Bond Market in general.
- The municipal market is estimated to consist of 20,000 plus outstanding debt instruments worth $2.7 trillion. Over the last 10 years annual issuance has ranged from $287.2 billion to $429.9 billion per year. The 10 year cumulative default rate through 2009 for all rated municipal bonds, including those rated below investment grade, ranges from 0.04% to 0.29% based on reporting from all three major rating agencies.
- There is an excellent Fitch research report dated November 16, 2010, U.S. State and Local Government Bond Credit Quality: More Sparks than Fire, contact us for a copy.
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