A strong Consumer Confidence number brought the bond bears out of the woodwork on Tuesday, driving Treasury yields to a 12-month high. The 10-year and 30-year Treasury levels hit daily closing highs of 2.15% and 3.31%, respectively, before settling down at 2.13% and 3.27% as of last night.
Interestingly, the 10-year Treasury yield is now competitive with the S&P 500 dividend yield, thus putting pressure on dividend-driven equity sectors such as utilities or mortgage REITs.
High yield and unrated municipals will continue to account for the bulk of muni defaults, as can be expected.
Overall, this month has witnessed a violent correction for fixed-income securities in general, and municipals continue to weaken along with Treasuries, even in the face of fairly limited supply. Arguably, the outlook for tax-exempts might look even worse were it not for the robust reinvestment flows projected for June and July. Of course, now that the debate about the “Great Rotation” out of bonds into stocks has been revived, there’s no assurance that investors will plow the cash from their bond redemptions back into any fixed-income instrument.
With the May employment report not due out for another full week, there should be ample time for more market volatility next week.
Where the Real Risks Are
For quite a while now, we’ve been of the opinion that talks about muni default risk are somewhat misplaced. Let’s face it, even after the economic hardship of the last five years, the default rate in investment grade munis continues to be insignificant (less than 1% on a cumulative basis according to Standard & Poor’s latest statistics). True, there have been a handful of large, headline-grabbing bankruptcies (Jefferson County, Harrisburg), not-so-large but potentially game-changing bankruptcies (Stockton, San Bernardino) and near-bankruptcies (Detroit).
However, as many market experts have pointed out, bankruptcy does not even necessarily lead to actual default and recovery prospects on essential service debt remain as high as ever. State finances overall are benefiting from rebounding revenues and pension and OPEB funding issues are being addressed (or at least vigorously debated) at statehouses around the country. The record-setting stock market has also restored asset values in many of these pension plans, thus providing some short-term funding pressure relief.
… bondholders must do their credit homework and know exactly what secures their bonds, as the market will become much more discriminating in terms of credit quality.
This shouldn’t be used as an excuse for credit complacency, however. High yield and unrated municipals will continue to account for the bulk of muni defaults, as can be expected. Much of the recent improvement in state finances has come at the expense of local governments and agencies, which have yet to see any significant turnaround in their fiscal fortunes. With bond insurance no longer available as a credit risk transfer mechanism, bondholders must do their credit homework and know exactly what secures their bonds, as the market will become much more discriminating in terms of credit quality.
Unfortunately, even as credit concerns are starting to abate for the current economic cycle, there are still more potential ways to lose money in munis than from actual default.
At this point in the cycle, we believe the greater risk facing tax-exempt bondholders is duration risk (or “interest rate risk”), not credit risk. Ironically, high grade municipals are the most exposed to interest rate risk, particularly those with relatively low coupons and longer maturities (in other words, longer durations).
High yield issues tend to hold up better during the initial stages of a bond market selloff, due primarily to their inherently shorter duration. Also, institutional investors tend to sell their high grade, lower-yielding holdings first when they need to raise cash, for a couple of reasons: (1) they want to preserve their tax-exempt income stream and (2) they can get better liquidity with high grade bonds. Should the selloff prove sustainable, then high yield paper will eventually gap down in price also, but still at a slower pace than your generic high grade issue.
Another element of risk, a product of current near record-low interest rate levels, is what we call “premium risk”. After the powerful rally of the past two years, any outstanding tax-exempt bond that hasn’t been refunded is probably trading at a fairly high dollar price premium over par. Should any kind of credit concern arise, the value of the bond will quickly decline to par, wiping out the premium. To take a current example, any Puerto Rico issue still trading at a premium would be vulnerable to such a correction. Should the market start to price in a potential default, even if investors believe they will be made whole by the Commonwealth, they can only expect to get par and thus will lose any market premium on their bonds.
Aside from “premium risk”, investors should also take note of potential “spread risk”. This is defined as the risk that your bond holding will trade at a wider spread to the AAA scale, either as a result of credit-specific concern or as a result of a general loss of risk appetite in the marketplace. The recent shortage in yield paper relative to investor demand for income has led to significant spread compression in the muni market. In a bull market like the one we’ve experienced over the last decade, spread risk only leads to relative underperformance: your bond may not appreciate as much as another but there’s no real loss. However, should we get into a real bear market, spread widening can lead to real absolute losses on top of losses attributable to a general rise in rates.
All this goes to show that, more than ever, credit vigilance should be maintained as we enter a potentially more volatile period for fixed-income investments.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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