Municipal bonds have, traditionally, been much less volatile than Treasury yields – and muni yields have (like bond yields in most other markets) rose with Treasury yields. The chart below illustrates rolling one year changes in Treasury and 10 year AAA muni bond yields between 1986 and 2012.
As shown above, the sensitivity of muni to Treasury returns is roughly 0.5. Many investors believe this relationship exists because investors tend to compare the after-tax returns of Treasuries to municipal yields. Why has that relationship changed recently? Fundamentally, the answer is because of the fear of default. Specifically and recently, last year investors ran worried as interest rates began rising - and that fear intensified after Detroit filed for bankruptcy and concerns for the finances of Puerto Rico ascended. Puerto Rico is one of the largest issuers of muni bonds with $70B of debt, and US investors have pulled over $20B from muni funds containing Puerto Rico’s junk-rated debt. These events have and heavy outflows have forced municipal bond managers to keep bigger positions of well-known and highly-rated securities. For that reason, prices fell sharply and muni yields rose more than they usually would, to include faster than Treasury yields, explaining the rise to these unusual circumstances.
This strange relationship is beginning to wind down. Currently munis have returned 2.2 per cent year-to-date, ahead of the broad US Treasuries index which has delivered 1.2 per cent. Investors deposited a net $342 million in January, a significant improvement from the nearly $10B that flowed out of muni funds in December. Nevertheless, the gains this year have come from interest rates dropping - the yield on the 10-year Treasury note has sunk to about 2.73 percent from 3 percent in early January. Most major news network and financial advisory firms are praising an investment in municipal bonds this year, and most retail investors will surely tag along. A Google News search will present numerous articles journaling the pick-up in the muni marker. While there are certainly opportunities in munis this year, there are some significant concerns that could limit returns and further prolong this unusual muni market:
• Credit concerns: muni-bond fund managers say they are hearing more questions now from investors about Puerto Rico. Although the default rate for municipal bonds in Puerto Rico remains below 1 percent, a reoccurrence of negative attention can be devastating for the muni market.
• Tax exemption: Congress is debating whether to strip away, or at least reduce their tax-exempt income. If the proposals turn into law, it could drive down demand.
References used:
1. http://www.bostonglobe.com/business/2014/03/09/can-calm-last-municipal-bond-market/pePmcosGXSuLq5YgeFI6MO/story.html
2. http://www.reuters.com/article/2014/02/21/us-puertorico-funds-idUSL2N0LP2MK20140221
3. http://www.ft.com/intl/cms/s/0/35f47b76-93ed-11e3-a0e1-00144feab7de.html#axzz2voEP7jem
4. http://blog.alliancebernstein.com/index.php/2013/07/25/municipal-bonds-equipped-to-weather-rising-rates/
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