Municipal bonds are a rare asset class with an outsized retail influence. According to the Investment Company Institute, individual investors hold about 35% of muni bonds directly and another 36% indirectly in mutual funds, closed-end funds and exchange-traded funds.
Unlike insurance companies, pension managers and other investors with an unlimited investment horizon, retail investors are susceptible to headline risk — the possibility that a news story will hurt a security’s price. (Remember the anxiety after Meredith Whitney’s prediction of a wave of muni defaults back in 2010?)
Since April, retail muni debt products have had hundreds of millions of dollars in net outflows each week as advisors and their clients pull away from them. Does this reflect wise investing or misplaced fears? Let’s look at the three leading cases for dumping muni funds.
1. Puerto Rico
There’s no doubt Puerto Rico has problems: notably, private sector unemployment and underemployment, population decline and a reliance on governmental employment. The perceived risk here is that some mutual funds and ETFs have relied too much on Puerto Rico’s triple-tax-exempt status and generous yields and are overexposed to a possible default.
Investors were rattled when the island’s legislature tried to avoid debt payments by enacting a law that would have allowed PREPA (the island’s electric authority) and other municipal agencies to renegotiate or restructure their debt obligations under the authority of local courts. A federal appeals court sided with the mutual fund sponsors OppenheimerFunds and Franklin Advisors, however, and said, “Puerto Rico, unlike states, may not authorize its municipalities, including these utilities, to seek federal bankruptcy relief under Chapter 9 of the U.S. Bankruptcy Code.”
Although Puerto Rico’s governor has stated that the commonwealth doesn’t have the money to pay its debts, there’s reason to believe this may have been political rhetoric to appease voters disappointed with new taxes. (Puerto Rico Treasury Secretary Juan Zaragoza also told a radio audience that the commonwealth has money to pay its debt but believes it should be used “for other things.”)
There’s certainly a stated unwillingness by Puerto Rico’s politicians to make the hard choices necessary to service the island’s heavy debt, but the ability to pay it is more important. In that regard, things are looking up. For example, the government began its new fiscal year on July 1 with a balanced budget. Its general obligation debt service this year will cost about $1.5 billion from its general fund revenue of $8.5 billion (about 17% of the budget — high, but manageable).
The island’s decision in early August to default on a bond that requires an appropriation by the legislature (and hence is not the general obligation type held by mutual funds) is further evidence of unwillingness.
There are also indications of improving economics in the private sector (the Q4 Business Employment Dynamics report from the BLS pointed to gross job gains exceeding gross job losses) as well as increasing per-capita income.
Individual investors are not the only ones exposed to Puerto Rico. Low interest rates, low default rates and a lack of big distressed-debt opportunities elsewhere will keep large private investors (like hedge funds) included in the mix, and they are some powerful, organized allies.
How long they’ll stay around and keep pressure on the commonwealth to fulfill its obligations depends on when those factors change, but there’s little on the horizon today that could change that situation.
Given an aging and declining population, from a demographic perspective it’s debatable whether Puerto Rico’s debt is sustainable in the very long run, which makes short-term comparisons to Greece all the more appropriate: most of the debt has been issued to finance Puerto Rico’s deficit (kicking the can down the road), it can’t deflate its way out and it can’t restructure in bankruptcy court. Headline risk won’t disappear, but Puerto Rico’s citizens have more to lose by defaulting than by working with creditors.
2. Issuance Glut
According to Thomson Reuters, U.S. states, cities, authorities and other municipal issuers sold $213 billion of bonds in the first half of 2015, nearly 49% more than in the year-earlier period. If that trend continues, the muni market would be on pace to reach $426 billion this year, which is close to record territory.
But, despite the activity, there are reasons to doubt that 2015 will finish at a new volume high, mainly because much of this year’s issuance has been in refinancings to beat the clock before the Federal Reserve changes the overnight lending rate. (Refundings have constituted two-thirds of total issuance this year.)
This tidal wave of muni paper has sent long muni yields well above those of comparable Treasuries. For high-net-worth investors with higher marginal tax rates to consider, ratios above 100% (the red line in the chart) often reflect a pretty good bargain; they’ll receive the tax benefit of muni bonds for free.
Importantly, yield correlation between long-term munis and Treasuries has been very high (more than 90%) since 2013. Even if Treasury yields rise later in the year in response to Fed moves, the relative cheapness of munis should buffer them from volatility.
3. Treasury Market Swings
The 30-year Treasury started 2014 yielding 3.89%, rallied to 2.25% at the end of January 2015 and backed up to about 3.08% near the end of July. The substantial yield increases since the late-January lows have offset the benefit of the relatively higher coupons found last year. So, what prompted this sudden bout of volatility?
Fingers can be pointed at two developments: fears over the timing of the next Fed rate increase and concerns over the eventual outcome between Greece and its major creditors.
Although there is always some doubt about rate moves until they’re finally announced, odds are growing for something to happen in September. With a bailout deal reached with Greece (although that turmoil is hardly over), much of the Treasury volatility that was imported from Europe has eased considerably.
The remaining wild card — global growth — points to softer conditions abroad, since transportation indexes are very low and commodities as copper, aluminum and nickel are all near six-year lows.
While the case for imported inflation is all but dead, domestic inflation indicators — the last remaining cue for the Fed to give the “all clear” signal before tightening policy — are just a hair below the Fed’s 2% target and may be close enough for it to act. Waiting might force the Fed to ramp up more sharply than it would like, a situation that Janet Yellen has repeatedly warned against and another argument for a September rate increase. Once that shoe has dropped, one more uncertainty will be removed.
Between headline risk, a glut of new issues and Treasury volatility, it has taken a strong stomach to ride out the waves that have buffeted the muni market.
With yields at their highest levels since last July, munis look attractively priced, and if outflows from muni mutual funds continue to diminish (just $75 million of weekly net outflows in mid-July), it won’t be long before the retail channel perks up and feasts on tax-exempts again.
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