Russell’s view: Municipal Bonds Attractive Relative to Corporate Bonds
What’s behind the municipal volatility?
As a retail-driven market, municipal bonds have historically been subject to headline news risk that has had the potential to magnify losses beyond what might be expected given market fundamentals. Today, the exodus has been driven by a number of factors, notably: the Detroit bankruptcy filing, a general rise in interest rates, and lower dealer inventories that have created liquidity concerns. Dealers, those who buy and sell municipal bonds in the secondary market, are carrying less inventory today as a result of regulatory changes, which can lead to liquidity concerns when inflows and outflows are heavy. The fall in prices is not new to fixed income in 2013, but in Russell’s view, the magnitude of the price drop has created a potential opportunity relative to corporate debt.
The last time we saw such volatility was after December 19th, 2010 when Meredith Whitney, the analyst famous for issuing an accurate forecast of Citibank during the most current financial crisis, appeared in a televised interview on 60 Minutes1, where she predicted that between 50 and 100 municipalities would default, totaling hundreds of billions of dollars in losses. By the end of January 2011, outflows out of municipals forced the yield ratio between municipal debt and corporate debt to hit 99%, a level not seen again until today.2
To give some context, as of 8/31/2013, the 10-year average for the ratio is closer to 75%.
In order to assess the dislocation, we need to determine if this time is different, if the market is pricing in accurate fundamentals, or if irrational investor behavior has created an opportunity. We’ve already highlighted some of the factors behind the outflows, but it’s also worth highlighting some of the fundamentals that make this a potentially attractive opportunity:
- The tax exempt status of municipals helps justify the historical municipal/corporate yield ratio of approximately 75%.
- Historically, the municipal default rate has been lower than that of the corporate sector.3
- On August 20, 2013, Moody’s made an upward revision, from negative to stable, to its outlook for U.S. states, citing supportive growth in state revenues and reserves. The rating had been negative for the past five years.4
- Although both indices used for this analysis are rated investment grade (BBB and higher), the average credit quality of the municipal bond index (AA3/A1) is currently higher than that of the U.S. corporate bond index (A3/BAA1), as of August 30, 2013. Essentially, this means the municipal bond index is producing similar yield for less credit risk, according to the rating agencies.
- The municipal bond index currently has a duration of 6.02, while the U.S. corporate bond index has a duration of 6.71,5 as of August 30, 2013. Essentially, this means the municipal index is producing nearly equivalent yield for less interest rate sensitivity, an important risk factor, especially in the current environment.
Historically attractive at such levels
As previously mentioned, the average municipal/corporate yield ratio over the previous ten years is closer to 75%. The last time the ratio was near the August month-end level (and also the only other time it has been that high in the previous 10-years) was in January of 2011. Subsequently, municipal bonds outperformed corporate bonds by nearly 3.8% from the one-year period between January 31, 2011 and January 31, 2012. The ratio began this period at 99% (which is the same level as August 2013 month end) before it eventually fell to 72% in January 2012.
The bottom line
Create context for your clients
In Russell’s view, recent market dislocations have created a potentially attractive opportunity in municipal bonds – when compared to the relative value of corporate bonds. Historically, such valuations have favored municipal bonds for both tax aware and tax exempt investors. Although pockets of trouble do exist in the market and investors must be cautious, Russell believes the overall municipal market fundamentals continue to show positive signs of improvement.
David Jurca is a research analyst, global fixed income, for Russell Investments
1 60 Minutes is an American television newsmagazine program that is broadcast on the CBS television network. Meredith Whitney is a banking analyst, based in New York City, and frequent contributor to various news programs. Both are used in this illustration for illustrative purposes only.
2 Yield ratio is based on the Barclays Municipal Bond Index relative to Barclays U.S. Investment Grade Corporate Index.
3 Special Comment: U.S. Municipal bonds defaults and recoveries 1970-2012, Moody’s Investors Service research, May 7 2013, pg. 14
4 Barclays Municipal Bond Index and Barclays U.S. Investment Grade Corporate Index.
5 Duration measures the level of price sensitivity for a 1% change in interest rates.
The Barclays Municipal Bond Index is an index, with income reinvested, representative of the tax-exempt municipal bond market with a maturity of at least one year.
Barclays U.S. Corporate Investment Grade Index: Dollar denominated, investment grade, publicly issued securities with a minimum final maturity of at least one year, issued by both corporate and non corporate issuers.
Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.