After suffering through a brutal summer, fixed-income investors returning from the Labor Day weekend found some solace in this morning’s rather disappointing jobs report. Non-farm payrolls for the month of August came in at 169,000, slightly lower than the street consensus of 175,000. The killer number though, was the large downward revision to the June-July number of 74,000. Although the jobless did inch down to 7.3%, much of that was attributable to a shrinking labor force participation rate.
All this was enough, along with the ongoing geopolitical risks related to the Syria situation, to drive 10-year Treasury yields back down to the 2.93% range after they flirted briefly with the 3.00% handle earlier in the week.
In and by itself, a lackluster jobs report probably will not dissuade the Federal Reserve from starting the process of winding down its quantitative easing efforts when it meets on September 17-18. It may, however, lead to a reduction in the size of the initial tapering effort and that’s obviously what the bond market is betting on.
Such optimism might be short-lived, however, as the government debt market will be faced with more supply next week.
Fear-Mongering in Today’s Muni Market
As we wrap up our first week back to work after the Labor Day holiday, we thought it might be worthwhile to take stock of where the muni market currently stands.
By most measures, it has been a tough summer for tax-exempt investors. As of 8/31/13, the Barclays Municipal Bond Index showed a three-month total return of -5.06%, with the Puerto Rico Index down a stunning -16.67% over the same period. The weekly average yield to maturity of the Bond Buyer Municipal Bond Index stood at 5.32% for the week ending September 5, 2013, its highest level since the week ended June 2, 2011.
Nowhere is the muni market’s
inefficiency more evident than in its reaction to the Puerto Rico situation.
The municipal market’s retreat started in May with the general bond market rout related to the potential end of the Fed’s quantitative easing efforts. However, it has picked up steam over the past two months on more idiosyncratic grounds: the Detroit bankruptcy filing and, more recently, renewed concern about the potential systemic risk posed by Puerto Rico.
As one of our fixed-income colleagues pointed out recently, there is no such thing as “Buy the Rumor, Sell the News” in munis, as the tax-exempt market seems notoriously inefficient in pricing and incorporating credit information. After more than 30 years as a market practitioner, I’m still constantly surprised by how much bond prices can be significantly affected by what is widely considered as “old news.”
Nowhere is the muni market’s inefficiency more evident than in its reaction to the Puerto Rico (PR) situation. The island’s precarious fiscal and economic condition has been known and widely debated for years, with the latest wave of credit concerns starting in the spring of 2012. That was when PR credit spreads started to widen out dramatically, with the island’s G.O. bonds trading at +300 versus AAA by the end of 2012. PR spreads did recover modestly in the first quarter of this year as the new Padilla Administration was able to push through a modest pension reform package and various revenue increases.
However, as we’ve been saying for a while, all the spread widening during 2012 didn’t really hurt performance as long as the entire market kept rallying. Once rates started to rise, however, wider spreads have led to significant market value losses.
Just two weeks ago, Barron’s published a cover article titled “Puerto Rico in Trouble”. The article contained little new credit information, yet it has increased selling pressure on PR paper and pushed PR spreads wider by another whopping 100 basis points in the span of a few days. More recently, a Forbes article likened the muni funds’ Puerto Rico exposure to another Detroit, with provocative language bordering on fear-mongering. Both of these articles drew their impact from highlighting the muni funds’ excessive exposure to a marginal credit such as PR. Apparently, many fund shareholders, particularly those invested in State-specific funds, never realized that their fund managers had been relying on triple tax-exempt from US territories to meet the funds’ investment objectives. Never underestimate the shock impact of seeing a negative headline splattered across your grocery aisle.
At this writing, yields on longer-dated Puerto Rico bonds are topping 8.00%, with the Commonwealth G.O.s in 2037 now trading at +397 over AAA. This puts PR squarely in B-rated junk bond territory. Depending on your investment objectives, this may be viewed as a risk or an opportunity. We’ll explore the relative value of various PR bonds in next Tuesday’s column.
To a large extent, the muni market’s inefficiency stems from the dearth of objective information available to such investors. Individual muni buyers usually get their market or credit information through one of two sources: either their broker-dealers or their mutual fund managers. Neither source of information can be relied on as particularly objective. This has left a gaping hole for the general media to fill. After years of dismissing the muni market as a boring playground for the high net worth crowd, the press has now discovered that tax-exempts do have risks and have gone after them with a vengeance. Unfortunately, much of the recent media coverage has verged on sensationalism, creating a sense of panic among retail investors. No wonder the latter have reacted with their feet, exiting their mutual funds to the tune of almost $25 billion over the past 15 weeks.
As regular readers of this column already know, we’ve been among the toughest critics of Puerto Rico issuers. However, we’ve also given credit where credit is due. We’ve applauded the Padilla Administration’s efforts to deal with the Commonwealth’s revenue collection problem while still worrying about the continuing decline in economic activities. Certainly, anything less than a measured assessment of the risk and return merits of PR bonds would be a great disservice to the individual investors that provides the foundation to our market.
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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