As we near the end of the first quarter, investment grade tax-exempt bonds tracked in the S&P National AMT-Free Municipal Bond Index have returned 0.93% year-to-date underperforming relative to the over 2% return of the investment grade corporate bond market tracked in the S&P U.S. Investment Grade Corporate Bond Index.
What is going on? The reality is that there are both headwinds and tailwinds buffeting the municipal bond market.
First, some potential headwinds for municipal bonds for the rest of 2015:
- Retail Sentiment: The municipal bond market is heavily driven by retail investor sentiment. If ‘mom and pop’ don’t like municipal bonds then fund flows will most likely be negative. The more negative headlines the more likely that retail sentiment turns negative.
- Puerto Rico: This is an ugly and complex situation that is likely to lead to some massive defaults of Puerto Rico revenue bonds. So far, the S&P Municipal Bond Puerto Rico Index has dropped 1.34% in March eroding the previous two months of positive performance. State bond funds with Puerto Rico bond exposure are impacted on two fronts 1) bond prices falling and 2) possible lack of liquidity when and if they decide to sell the bonds. The uninsured bonds are included in the S&P Municipal Bond High Yield Index and the recent drop in bond prices is helping to weigh the high yield segment down. There are no Puerto Rico bonds in the S&P National AMT-Free Municipal Bond Index.
- Illinois and New Jersey: Each of these states has pretty large pension short falls to negotiate and this may result in headline after headline of bad press.
- Chicago: Is Chicago is the next Detroit? I don’t think so. However, how the Windy City deals with its budget and obligations is most likely going to be closely watched again creating headlines.
- Rising Interest Rates: Bonds are bonds, if yields rise bond prices go down.
Some potential tailwinds for municipal bonds in 2015 include:
- High quality: The investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index are incrementally higher quality than their corporate counterparts. Please refer to Should Municipal Bonds Be Considered Core? for more detail.
- Supply and demand:
- No tax relief in sight: Demand for tax-exempt bonds is in large part driven by the current tax environment.
- New issue supply: Demand still outpaces supply. While new issues have been increasing, the volume is partly driven by refunding bonds replacing higher yielding bond issues.
- Diversification: There are tens of thousands of municipal bond issuers from small local municipalities to states and territories. The vast majority are investment grade. There are over 10,000 bonds tracked in the S&P National AMT-Free Municipal Bond Index and all are investment grade.
- Comparative yield with less duration risk: Relative to other investment grade fixed income asset classes, investment grade municipal bonds still provide comparative yield when viewed from the Taxable Equivalent Yield perspective. Using a 35% tax rate the Taxable Equivalent Yield of the S&P National AMT-Free Municipal Bond Index is 2.91% while the yield of taxable bonds in the S&P U.S. Investment Grade Corporate Bond Index is 2.81%. Meanwhile, the duration of the bonds in the S&P National AMT-Free Municipal Bond Index is 4.7 years nearly two years shorter than its corporate bond index counterpart.
- Value in the ‘belly of the curve’: On a nominal yield basis a diversified basket of non-callable investment grade bonds tracked in the S&P AMT-Free Municipal Series 2020 Index (5 year bonds) have a higher yield than the 5 year U.S. Treasury bond. The same is true for the S&P AMT-Free Municipal Series 2024 index (9 year bonds) verses the 10 year U.S. Treasury bond yield. Note: S&P Dow Jones Indices has not yet launched the index tracking non-callable bonds in 2025.
And then there is the Tobacco Settlement bond sector.
- Tobacco Settlement bonds: This sector has a split personality – it is both a short term positive return driver and a long term hazard. So far in 2015 tobacco settlement bonds have returned over 3.7% as tracked by the S&P Municipal Bond Tobacco Index. Recent successful refunding bond issues have certainly helped and no defaults are imminent but the long term future is clouded (I have called it a “dark cloud on the horizon”) as these bonds are dependent upon U.S. sales revenue of tobacco products. The long duration of bonds in this sector also make it prone to dramatic price changes when yields change. Tobacco settlement bonds are excluded from the S&P National AMT-Free Municipal Bond Index.