Municpal Bond Landscape

A look back at 2011
Presented by Michelle Mabry

One year ago, if I had told a colleague that municipal bonds would outperform almost every asset class outside of long Treasuries, he or she would have likely thought that I was crazy. Fast-forward to the present day and that scenario is a reality. Municipals ended 2011 with a return just north of 10 percent[1], second only to the “safe haven” of U.S. government obligations. There are many factors which have contributed to this performance, a few of which we will discuss here.

First and foremost, most municipal analysts, portfolio managers, and general market professionals knew right away after analyst Meredith Whitney made her outlandish claims last December about a forthcoming municipal bond disaster that the claims had no basis in fact. Many others observed about midway through this year that her doomsday forecasts were not materializing, giving investors more confidence as prices began to stabilize.

Second, the lack of supply during the early part of the year, caused by multiple factors, including the expiration of the Build America Bond program, limited liquidity and created excess volatility in the system. As we moved into June and July, we saw investor confidence return; and, with that, so did supply. Though not at the levels in line with historical averages, there was at least improvement and a more liquid secondary market.

Third, local governments made strides in balancing budgets with a combination of spending cuts, tax increases, and improvement in tax revenue collection. This structural progress, along with cheap financing, allowed municipalities to come to market with offerings that further enhanced liquidity.

Fourth and finally, the global macroeconomic and political concerns, including the U.S. debt ceiling debate and the eurozone debt crisis, drove investors into perceived safety assets. As an asset class, all three sections of the municipal curve—short, intermediate, and long securities—experienced inflows of just under $13 billion during the third quarter of 2011 alone. This has continued through the fourth quarter, with short and intermediate bonds seeing the majority of inflows (see Figure 1).

As we move into 2012, there are several themes that could affect the municipal markets. Three major ones include:

         1.           Interest rates
         2.           U.S. economic recovery
        3.           Eurozone sovereign debt

Interest rates
At present, we are at or near historical lows for 2-year and 10-year Treasury notes, and the fed funds rate is in a range from 0 basis points to 0.25 bps. Eventually, with the economy on the mend, we believe rates will begin to creep back up, as investors move their cash out of the safe havens and into riskier assets. Although we don’t expect this to happen for some time, there is always the chance that we see faster improvement in economic data. When this does happen, we will likely see borrowing costs rise for municipalities.

U.S. economic recovery
This factor has similarities to what we discussed above; however, there are some differences. During the past year, municipalities have attempted to balance their budgets through a mix of tax increases and spending cuts. Should the economy maintain its recent positive direction, we could see the employment improve, which, we hope, would lead to an improvement in the housing market as well. This would increase two major forms of revenue for the states: income tax and property tax. Consequently, this uptick in revenue would aid states in their budget planning, although continued cuts would be needed to sustain fiscal health.

Eurozone sovereign debt
Despite some positive signs showing up in economic data for the U.S. over the past few months, the situation in Europe still hangs over our heads like a black cloud. The inability of the member states and the European Central Bank to stem the crisis has continued to create volatility and uncertainty in markets around the world. A deep recession in Europe would likely have an adverse affect on the global economy, including the U.S. Every day that passes without a resolution makes this scenario seem like more and more likely. How much a recession in Europe would affect us remains to be seen; however, it has become apparent to us that the U.S. economy would be affected on some level.

What to expect in 2012
Although we think we are unlikely to see double-digit returns again in 2012, there are pockets of opportunity within the municipal space. A lot of what happens will depend on Washington, which could hurt more than help if decisions get dragged out. Many sectors, such as hospital-related bonds, rely heavily on federal government subsidies. Any cut to these payments could have an adverse affect on dependent institutions. The main focus for our clients heading into 2012 is one of increased due diligence which we think is crucial in the current environment.

 

1 Barclays Municipal Bond Index. Past performance is no guarantee of future results.
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