The past few weeks saw the tax-free municipal bond market back up in yield – and down in price. May 2013 was the worst May for the muni market in more than 25 years. And May is traditionally a good month for the muni market because the tax selling of April is over, and the large reinvestment months of June and July lie ahead.
What made this May different for munis?
- The rapid sell-off in the US Treasury market. The 10-year US Treasury moved up in yield from 1.67% at the end of April to 2.12% at the end of May, while 30-year Treasury bond yields moved up from 2.87% to 3.28% at month end. The rapidity of the backup spilled over into the tax-free market, even though it still had relatively cheap yields.
- The better numbers in the housing market were also partly to blame. The Case Shiller 20 City Home Price Index rose over 8% last year. Certainly some areas saw more dramatic improvements. There tends to be a positive feedback loop with housing as fewer homeowners have negative equity in their homes. This trend leads to fewer foreclosures by banks, which leads to better bank balance sheets that can encourage more lending to refinance, which in turn feeds back into stronger housing markets. And so on.
- The dealer community lacks the liquidity that it enjoyed prior to the financial crisis. Many firms don’t have the capital they had prior to the financial crisis and, in any case, are rationing to a greater extent the capital that they do have. Many smaller firms just step away from the market entirely during a muni yield backup. Their retreat means liquidity can leave fast in a market that changes so quickly.
- There certainly was some transition of money from the bond market to the stock market. Certainly bond fund flows were more muted as low yields have driven some investors to the equity market.
Where does that leave tax-free bond market?
- In our opinion, it is the best opportunity in the municipal bond market in the past twelve months. Though absolute yield levels have risen a lot, where one can BUY bonds – on the bid side – is very cheap compared to just a few months ago. This is the first chance to buy some longer-term bonds at +4% tax-free yields in superior credits. In some cases we are buying some longer bonds with 3.25 to 3.75 coupons that were issued a little more than six months ago at 10-14 point discounts from their issued price.
- The yield ratio of munis to US government bonds is dramatically cheap. Many of the “beat-up” discounted bonds are at yield ratios of 125-135% to US Treasuries. Most times, when Treasury yields rise, muni/Treasury ratios drop, simply because the tax exemption of the municipal bond means it doesn’t need as much of a rise in yields to produce the same taxable equivalent rise compared to Treasuries. This makes them particularly attractive.
- Marginal federal tax rates are higher this year. The top marginal tax rate went from 35% to 39.6%; furthermore, the Obamacare tax of 3.8% on investment income (tax-free bonds excluded) raises the top marginal rate to 43.4%. To put this in perspective, a 4.15% tax-free yield is now equivalent to a taxable yield of 7.46%. It is even higher when you throw in state taxes, if applicable.
- Municipal Supply remains constrained. The Bond Buyer Visible Supply is under $7 billion; the average supply number over the past year has been about $8.5 billion. Voters are not nearly as willing to sell debt in the leaner post-recession period.
- We are entering the heaviest “rollover period” of the year, with billions rolling over in coupon payments, called bonds, and maturing bonds. That should provide a strong bid to demand side as things settle down
- Inflation has DECREASED, not increased. Six months ago, trailing headline inflation was 2.2%. It is now 1.1%.
When you add up the evidence – cheaper yields, higher yield ratios, muted supply, higher taxes, lower inflation – as well as an overall better credit picture for municipalities, we think the current tax-free bond market climate is very attractive and offers opportunities for portfolios not seen in a long time. And we are acting accordingly.