A few observations about the muni market
There is no shortage today of opinions on the state of the municipal bond market. The views vary from Meredith Whitney and Jeffrey Gundlach discussing dire municipal market scenarios to many respected market commentators arguing the other side. Given these varied opinions on municipal bonds, I want to share a few observations regarding the broader muni market and historical defaults:
- There are over 40,000 issuers of municipal bonds in the U.S.1, and over 46,000 issues in the BarCap Municipal Bond Index alone.
- The muni bond market was approximately $2.9 trillion in size as of 20102.
- Muni bond defaults in 2010 totaled $2.7 billion during the year2.
- That’s a default rate of less than 0.1%.
Granted this rate may increase in 2011, but you get an idea of the sheer size of the municipal bond market and the very small default rate of 2010.
The latter part of 2010 was undoubtedly a challenging period for many municipal bond funds with many reporting negative returns. When investors saw the negative returns, coupled with uncertainty around the fiscal health of local, city, and state governments, it caused a great deal of investor unease and many wondered if they were witnessing a repeat of markets during 2008. I think it’s important to point out a few of the main drivers of these negative returns:
- The yield of the 10–Year Treasury increased nearly 100 bps during the fourth quarter.
- The future of the Build America Bond’s (BAB) program was in doubt. With the belief that this program would expire, many municipalities tried to take advantage with increased issuance (increased supply). Remember that the BAB Program was launched during the Financial Crisis as a way to help municipal governments issue debt.
- Many investors were anticipating the expiration of the Bush-era tax rates. If marginal tax rates had increased, municipal bonds would be more attractive due to their favorable tax treatment.
- Also, many investors had been purchasing municipal bonds for their attractive yields. Many did not appreciate the longer duration (more interest rate sensitive) or poorer credit quality many of these funds were taking to get the attractive yield. When rates increased, these bonds often had the most challenging returns.
While it seems that there may be increased defaults in municipal bonds in 2011, thorough bond research and a strong understanding of the revenue stream backing each bond will be more important than ever. To ignore, or stay away from, the entire municipal bond market seems to be very extreme. Municipal bonds should continue to play an important role in a tax-aware account and sometimes even for non tax-aware accounts.
1 “The Next Big Short.” by John Rubino, CFA Magazine Nov-Dec 2010
2 Distressed Debt Securities Newsletter, J.P. Morgan Asset Management
Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages.