Many high-quality municipal bond issues are now trading above U.S. Treasuries on a pre-tax yield basis and this situation begs the question whether tax-exempt securities provide a new opportunity for institutional investors.
We strongly believe that the primary role of investment-grade bonds in a globally diversified portfolio is to provide a steady stream of income with a high probability of principal preservation. Pushing the envelope of risk with investment-grade fixed income hardly ever makes sense because rarely are you compensated for the incremental risk.
Key aspects of the current municipal bond market shake-up, however, indicate opportunities may exist for institutional investors.
Changes in the Landscape
Without doubt, there are many challenges across the municipal sector, but the doomsday scenario painted by some market pundits is exaggerated. Are there issuers at risk of default in the municipal bond market? Absolutely. When these defaults occur, will they periodically send a shudder through the broader municipal bond market? Probably. Will these reactions be exaggerated and provide opportunities for investors able and willing to sell liquidity to the market? Very likely.
There’s no question that the risk profile of the municipal bond market is different from what it was 10 or 20 years ago. The AAA mono-line insurance wrap, which raised bond ratings, is no longer a source of comfort. The underlying credit fundamentals have, in general, deteriorated from a once unassailable position. The market is riskier than it used to be and one should expect higher price volatility going forward, but it very much remains primarily an investment grade bond sector.
Indeed, the typical investor has more to fear from rising interest rates than defaults. Northern Trust’s risk sensitivity analysis shows high-quality municipal bond portfolios lose more money from higher interest-rate and inflation shocks than they do from the repeat of credit shocks, such as the 2008 financial crisis or the Long-Term Capital Management bailout.
Yields Tell the Story
When municipal bonds offer attractive yield advantages, a high-quality municipal bond portfolio can and should be compared with the alternative of owning U.S. Treasuries or investment-grade corporate bonds. In fact, many states have economic profiles much more attractive than many sovereign nations that consistently tap into the global investor base. In mid-April, for example, a typical high-quality municipal bond portfolio with more than 60% of the issues rated AA or higher and 95% rated single A or higher provided an option-adjusted spread to U.S. Treasuries of 90 basis points for a nine-year duration.
As we saw in the fourth quarter of 2010, poor liquidity conditions can develop in a market dominated by sellers and, as a result, very solid bonds get re-priced to cheap levels. The increased volatility in the municipal sector might cause income-oriented investors to re-allocate some of their assets to government bonds. Other investors might use their municipal bonds as a funding source for a higher risk appetite for equities and alternative assets.
Institutional investors with long-term horizons, who up until now may have focused on U.S. Treasuries, sovereign debt and high-quality corporate credits, likely will discover attractive opportunities in the U.S. municipal bond market if they are willing to step into the breach.