Yesterday’s three hour trading glitch at the NASDAQ provided the markets with a welcome respite from their obsessive Fed-watching behavior. The minutes of the FOMC released on Wednesday failed to provide further clarity as to the eventual timing of stimulus reduction but they did reiterate the Committee’s support for the plan outlined back in June. Thus, the market consensus continues to lean toward a September time frame for the beginning of Fed-tapering efforts.
In the meantime, traders continue to get whipsawed by recent economic data. Earlier in the week, the four-week moving average of jobless claims fell by 2,250 to 330,500, the lowest level since November 2007. This pushed the yield on 10-year Treasuries to 2.93% on Thursday, a fresh two-year high. This morning, yields dropped again toward 2.83% as new home sales were reported much lower than expected. And so it goes as we lurch toward the next potential market-moving event: the August Non-Farm Payrolls report due out September 6th.
One notable feature of this week’s government bond market action: a modest flattening of the Treasury curve. The slope between 5- and 10-year maturities tightened by five basis points to 119. The 10-to-30 year curve also came in about four basis points flatter, to 98 as of last night.
For muni investors, what’s worse than a headlock from San Diego ex-Mayor Bob Filner? Another record mutual fund redemption week, of course. Outflows from weekly-reporting municipal bond funds actually accelerated to $2.14 billion in the week ended August 21st, according to Lipper. The outflows mark the 13th consecutive week of investor withdrawals and set a new high water mark for the month.
In the absence of institutional demand, tax-exempt yields have continued to grind higher this week. Through Thursday, the 10 year AAA Municipal Market Data (MMD) scale has risen by 6 basis points to 2.94% while the 30 year yield climbed 7 basis points to 4.46%.
Where Do We Stand In Munis?
As we head into the waning days of the summer, this might be a good time to re-assess where things stand in the tax-exempt market.
In our piece from May 30, 2013 entitled, “The Real Risks In Munis“, we argued that duration risk or interest rate risk, not credit risk, should be the main concern for muni investors at this point in the economic cycle. This means that your muni bond exposure should be skewed toward issues that are less rate-sensitive and more credit-sensitive, assuming you have the tools to perform thorough credit research. It may come as a surprise to many retail investors that the highest-quality, most liquid long term bonds are also the ones most exposed to interest rate risk. They have the highest “market beta”, so to speak. Long-dated high grade bonds are usually the only things portfolio managers can sell to raise quick cash, so they tend to bear the full brunt of any market selloff.
Credit-driven investment opportunities on the other hand, particularly those secured by real assets, should benefit from an improving economic environment. Their higher coupon structure should also lead to a shorter effective duration.
Corporate bond investors appear to have gotten that message. According to Bloomberg, AAA-rated corporate bonds, perceived as having the highest duration risk, are actually yielding more than AA-rated debt. This paradoxical phenomenon has only occurred twice in the last decade.
Municipal participants, on the other hand, still flock to high quality debt as a defensive measure in times of market trouble. So far, this kind of reflexive move has not yielded beneficial results: year-to-date through August 22, 2013, the S&P Long-Term National AMT-Free Muni Bond Index is down 9.71%, underperforming the S&P Municipal Bond High Yield Index, which declined by 6.38%. We suspect the High Yield Index would look even better on a tax-adjusted basis since a larger portion of its return consists of tax-exempt income as opposed to capital gains or losses.
The massive media coverage about the Detroit bankruptcy has obscured one basic fact: away from pockets of local fiscal distress such as Detroit, municipal credit trends are in fact improving steadily. As of June 30, 2013, S&P reported 201 monetary defaults in the universe covered by its Municipal Bond Index. This equates to a default rate of only 0.48% of the total par value of the index, down from 0.54% as of December 31, 2012. Even S&P’s Municipal Bond High Yield Index recorded a quite manageable default rate of 4.45% of total par value as of June 30th.
For all the concerns about credit quality in the muni market, high yield spreads have widened only modestly, as far as we can tell, except for unique situations such as Puerto Rico and tobacco bonds. Some of the more recent, reasonably liquid high yield issues now offer an attractive combination of both higher absolute yields and slightly wider spreads. A case in point: the Iowa Fertilizer issue, which we discussed back in late April. The 5 1/4 % due 12/1/2025 initially came to market at a yield of 5.30% or about +336 vs AAA. At the time, while we thought the spread was adequate, the absolute yield level was hard to stomach: yields in the 5.00% for a “high yield” credit. That issue is now trading around 6.88% or +354, equivalent to a taxable yield of 11.39% for an investor in the top 39.6% top bracket.
The point to all this, of course, is that upgrading in quality without significantly shortening duration may not be the best course of action in the current market. Further, due to the steepness of the curve, one does give up significant tax-exempt income potential by sticking only to high grade intermediate maturities. We believe a selective downgrading strategy, backed by solid credit research, may deliver both shorter effective duration (relatively speaking) and much more attractive after-tax income. Since risk tolerance is a matter of individual preference, one doesn’t even have to venture into “high yield” to capture this opportunity: even the A to BBB quality range should offer better risk-reward characteristics than pure high grade paper at this point.
It also beats getting a headlock from Bob Filner.
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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