Municipals Bloom Amid Drought May 27, 2014

The municipal bond market is off to its best start since 2009, when attractive valuations in the wake of the financial crisis drew robust demand. The Barclays Municipal Bond Index is up over 5% year to date through May 16, 2014 — an impressive start for any fixed income sector in just under five months — and has recouped all of the loss from the 2013 pullback plus an additional 1%.

The municipal bond market has a history of bouncing back after a tough year, and the current bounce is similar to those witnessed in recent years [Figure 1]. In 2008, volatile and illiquid bond markets led to some of the most attractive municipal valuations ever witnessed relative to Treasuries. In late 2010, fears over municipal credit quality and a default surge led to lower prices that created another buying opportunity. Two factors differentiate the 2014 rebound, which actually began in late 2013 when prices first stabilized:

Treasury market strength. Treasury prices have increased despite steady reductions in bond purchases by the Federal Reserve (Fed) and indications that the Fed remains on track to eventually raise interest rates. But sluggish economic growth during the first quarter of 2014, Ukraine-Russia tensions, emerging market growth fears, and doubts over the timing and magnitude of future Fed interest rate hikes pushed Treasury prices higher, leading to broad bond market strength in 2014 and boosting municipal bond prices in the process. The 2011 municipal rebound was also aided by stronger Treasury prices, but Treasury strength resulted from a Eurozone recession and the Fed committing to refrain from raising interest rates — a different set of drivers.

Very limited supply. Municipal bond new issuance in 2014 is running approximately 30% below the 2013 pace and is on track to be the lowest in 10 years. Higher interest rates and the limited capacity of state and local governments to take on new debt have led to a significant reduction in new municipal bond issuance, helping municipal bonds outperform Treasuries in the process.

Municipal outperformance has led to more expensive valuations [Figure 2]. The average 10-year AAA-municipal-to-Treasury yield ratio still sits near a three-year low while the 30-year ratio has fallen to the lower end of its range.

On a long-term basis, municipal yield ratios remain attractive with average fully tax-exempt 30-year AAA municipal bond yields higher than comparable Treasuries. Some moderation may be likely now given the decline in yields in 2014. Average 10- and 30-year AAA municipal yields are down 1.0% and 1.1%, respectively, from 2013 peaks, and both yields are less than 0.5% above those prevalent at the start of the 2013 bond sell-off.

Caution Ahead

Investors are now starting to show some hesitation in response to lower yields and more expensive valuations. The amount of bonds looking to be sold, known as bid-wanteds, has increased in recent days and reflects the first signs of possible profit taking [Figure 3]. Such increases can lead to lower prices in response to rising selling pressure. Similar increases in bid-wanteds occurred in January and March of this year but were not sustained and created only minor price weakness. Also, recent increases in the amount of bonds available for sale are still below the elevated levels of 2013 that contributed to the bond pullback. The increase is therefore not a significant threat as of yet but is worth monitoring.

In conjunction with the first signs of selling, the month of June, especially the first half of the month, represents a difficult seasonal period for municipal bond investors as new issuance typically increases substantially.

June and July represent two of the biggest months in terms of maturing bonds, and municipalities often issue new debt to roll over maturing bonds. Caution ahead of the typical June issuance increase has historically led to
seasonal weakness for municipal bond investors [Figure 4] and it is among the weaker-performing months of performance, according to Barclays Index data. For example, the average monthly return in June has been historically only slightly positive for municipal bonds.

On a positive note, Figure 4 also illustrates that June has historically been followed by three of the strongest-performing months. Maturing bond proceeds are typically reinvested during summer months, boosting demand just as new issuance usually subsides. The seasonal summer trend did not hold in 2013, but with the limited supply trend likely to continue this year, June weakness may be limited ahead of a typically strong period for reinvestment demand. New issue supply and seasonal challenges may offset each other, perhaps posing no more than a hiccup similar to March of this year when municipal bond prices witnessed minor declines.

 

This leaves the taxable bond market — the other driver of strong year-to-date municipal performance — as the main catalyst for the next move in municipal bond prices, be it higher, lower, or sideways. For each rebound highlighted at the outset of this report, the direction of the Treasury market has provided a roadmap for the next significant move. Treasuries have shown remarkable resilience despite recent improvement in economic data that show a rebound in activity in the second quarter following a weather-depressed first quarter in 2014 (see Weekly Economic Commentary: Snapback, May 19, 2014). Lower Treasury yields reflect a market that needs more convincing as to the strength of the economy, but we believe the recent improvement will continue and ultimately pressure Treasury yields higher.

Absent a new bout of economic weakness, we see additional municipal price gains as limited. Prices may hang onto gains for some time, but nearterm opportunities are limited. On a longer-term basis, the favorable supply backdrop and 2013 increase in tax rates may help municipals be more resilient against the threat of rising interest rates. Over the shorter term, we continue to find the current pace of performance unsustainable, and current yields and valuations give us pause. We see recent strength as an opportunity to take gains and not as a sign of a possible buying opportunity

 

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Index performance is not
indicative of the performance of any investment.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Stock and mutual fund investing involves risk including loss of principal.

The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. One cannot invest directly in an index.

2014 Municipal Bond Outlook December 10, 2013

Municipal bond investors may face another challenging year in 2014, as we believe yields are likely to continue to move higher and bond prices lower. In most cases, we expect flat to marginally positive returns as interest income offsets price declines, but losses are likely if yields rise to the high end of our forecast. Similar to our outlook for the taxable bond market, we expect municipal yields to move higher by 0.3% to 0.8% compared to our outlook of a 0.5% to 1.0% increase for Treasuries. The smaller rise in yields compared to taxable bonds reflects our belief that municipal bonds will prove more resilient to rising interest rates in 2014 compared to Treasuries. Still, municipal bond prices will not be immune to rising interest rates in response to improving economic growth, reduced Federal Reserve (Fed) bond purchases, and the likelihood of an interest rate hike in 2015.

Early Headwinds

Municipal bond investors may face headwinds early in 2014 that may give way to potential opportunities later in the year. Three factors may contribute to early headwinds for municipal bonds.

• A difficult seasonal period. Late February to early April marks a historically difficult seasonal period in the municipal bond market. Investors often sell municipal bonds to pay for  capital gains taxes ahead of tax day, April 15. Since 2013 is shaping up to be a strong year for equity gains, tax-related selling is more likely to occur in 2014 and may pressure municipal bond prices lower.
• Lackluster demand.  Mutual fund outflows continue and may linger through the start of the New Year. Mutual fund outflows alone do not necessarily lead directly to price declines or preclude an increase in bond prices. However, fund flows are reflective of individual investor demand, which comprises 75% of the municipal bond market, and the persistence of outflows indicates that overall investor demand may still be soft to start 2014.
• Higher valuations.  Finally, municipal bond valuations have improved over recent months relative to Treasuries. Municipal-to-Treasury yield ratios are at the lower end of a six-month range [Figure 1], even if they remain elevated on a longer-term basis. As Figure 1  illustrates, municipal-to-Treasury ratios have failed to fall further in recent months after reaching current levels, leaving municipal bonds more sensitive to Treasury price movements. While ratios are still indicative of an attractive valuation over the longer term, the combination of continued outflows and the approach of a difficult seasonal period suggests limited scope for further valuation improvement at the start of 2014 to offset any price weakness.

Tailwind Opportunities

Early weakness may give way to tailwinds and buying opportunities later in the spring and summer of 2014. In 2013, price swings were often exacerbated by illiquid markets, and creating pockets of opportunity. The same may hold true in 2014 as liquidity remains constrained. Traditional taxable bond buyers entered the municipal bond market at times to take advantage of more extreme valuations and yields at or near 5% on high-quality bonds. Strong demand for long-term municipal bonds emerge as a greater number of high-quality municipal bond yields approach 5%. The 5% yield level has often brought out buyers and may do so once again [Figure 2].

A favorable longer-term supply-demand balance failed to benefit municipal bonds in 2013 but may provide support in 2014. According to recently released Fed data, overall municipal bond market growth remains stagnant [Figure 3], and through September 2013, the market of outstanding municipal bonds is almost $90 billion smaller than its peak during the fourth quarter of 2010. The municipal market is expected to show no growth in 2014, restricting the size of the market. This favorable supply-demand dynamic may give municipal bond prices a lift once early year challenges subside.

A Modest Improvement

While 2014 may be challenging, we expect an improvement over 2013. Average high-quality municipal bond yields are closer to the 5% level now than at the start of 2013. Yields may have less room to rise, and price weakness may be more limited compared to 2013. Therefore, we expect a modest performance improvement in 2014 versus what investors are on pace to experience for 2013.

We expect high-quality municipal bond returns to be flat to marginally positive in 2014 as interest income essentially offsets price declines associated with higher interest rates. We place a lower probability on yields rising by 0.8%, the top end of our forecast, since such an increase would require the Fed to indicate an earlier start to increasing rates than their current mid-2015 guidance. We think it is more likely the Fed may wait longer than mid-2015 to raise interest rates, which supports a more modest rise in municipal bond yields of 0.3% to 0.6%. Depending on maturity, interest income may offset price declines associated with rising interest rates.

Finding the Middle Ground

We favor intermediate municipal bonds due to better protection against rising interest rates while also providing upside potential. Long-term municipal bonds, although attractively valued relative to Treasuries, present greater interest rate risk. High-yield municipal bonds may also be impacted by rising rates. Unlike taxable high-yield bonds, tax-free high-yield bonds do possess much more interest rate risk. While a diversified portfolio of municipal bonds should contain long-term and high-yield municipal bonds, we believe more attractive entry points may arise over the course of 2014, and we focus on intermediate-maturity municipal bonds.

Getting Credit

Credit quality continues to improve on a broad basis for state and local governments. State and local governments have begun to add workers for the first time in years, and the state of California is projecting a surplus for the current fiscal year for the first time in almost a decade. The improving fiscal picture should keep defaults in check. Unique situations, such as Detroit’s financial failures, are likely to remain isolated and are not representative of the broad municipal bond market. The number of defaulted issuers is on pace to finish lower for a fourth consecutive year in 2013 according to Municipal Securities Rulemaking Board (MSRB) data and is likely to remain very subdued in 2014.

Not So Taxing

The topic of tax reform will overhand the municipal market, but odds of substantive reform remain very low for 2014. In an election year, a divided Congress is once again likely to struggle to find legislation that satisfies both parties. Furthermore, both Democrats and Republicans appear to better understand the role of the municipal bond market and the lack of viable alternatives to traditional tax-exempt financing for state and local governments. Eliminating the tax exemption of municipal bond interest may fail to raise desired revenues and have negative consequences for state and local governments.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

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INDEX DESCRIPTIONS

The Barclays Treasury index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include t-bills (due to the maturity constraint), zero coupon bonds (Strips), or Treasury Inflation Protected Securities (TIPS).

The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. All indices are unmanaged and include reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of future results.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

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