The U.S. Municipal Bond Market - An Analysis

By M. Isi Eromosele

The outlook for the U.S. Bond Market fundamentals remains positive for 2012.  

Investors should temper their expectations about total returns and prepare for increased price volatility as the market grapples with uncertainty surrounding supply and demand issues, federal government moves on taxation and financial market regulation as well as continued sovereign debt problems in Europe and the U.S.

There continues to be attractive opportunities in high-quality issuers of municipal bonds tied to essential services. U.S. investors might also want to include municipals in their fixed income portfolios for their competitive yield, lower volatility and low correlation with other asset classes.

State and local governments would remain creditworthy and the fundamentals of the municipal bond market are stabilizing. Even in a year filled with financial and political turmoil, municipal bonds have delivered impressive results. The stability of those returns was notable in stark contrast to the risk on/risk off volatility that characterized many other asset classes.

Many of last year’s biggest challenges for investors to linger through 2012, including:

• Changing patterns in the supply of, and demand for, tax-exempt bonds
• A larger federal role on taxation and regulation of financial markets
• Potential credit risks as Fiscal and economic problems spill over from Europe and Washington

While there continue to be opportunities, municipal bond investors should be cautious about the coming year, as the markets continue to digest some major issues that will likely influence bond valuations.

Issues Of Supply And Demand

The tax-exempt bond market has traditionally relied overwhelmingly on the individual investor for support. Recent Federal Reserve data show the $3.7 trillion municipal bond market to be significantly larger than the previous estimate of $2.9 trillion and a greater-than-expected dominance of retail investors.

Retail’s dominance of municipal bond demand poses liquidity challenges. For example, fears over municipal bond credit quality caused retail investors to flee the market during the fourth quarter of 2010.

Combined with a year-end surge in supply, municipal bond prices plummeted. These types of dislocations have the potential now to recur more frequently, presenting long-term investors with opportunities to capitalize on the market’s inefficiency and seek to purchase bonds with significant excess income and the potential for price appreciation.

Investors Might Consider Municipal Bonds

The municipal market opportunity is relevant for a broader range of fixed income investors, including those outside the U.S. Investors could look to municipal bonds, particularly U.S. state general obligations (GO), as a comparably yielding alternative to high-grade sovereign credit.

The competitive yield that municipal bonds offer, combined with their low volatility and lack of correlation with other asset classes, makes them an attractive option for investors beyond U.S. retail investors.

Modern portfolio theory argues that incorporating uncorrelated assets like municipal bonds should enhance the risk-adjusted returns of a total fixed income portfolio by

increasing diversification.

In comparison with where many indebted European countries are on their deleveraging paths, many U.S. states are further along in taking the necessary austerity measures to restore balanced fiscal operations.

As a result, event risk for these U.S. states will likely be lower, and credit quality (and credit ratings) significantly more stable for U.S. state issuers than for European sovereigns. The relatively low debt burdens and high financial liquidity make state GO debt attractive for bond buyers.

U.S. state GO debt is issued chiefly for capital borrowing and is self-amortizing, with an average maturity of approximately 11 years. In contrast, debt issued by France, Germany, Greece and Spain, among others, mostly cover operating shortfalls. With average maturities of six to seven years, these sovereign credits pose greater rollover risks for investors.

Historical data show that the highest quality state general obligation bonds, as well as high grade essential purpose revenue issuers, have traded relatively efficiently during periods of dislocation in the municipal markets.

Liquidity will improve as new classes of institutional investors are attracted to the municipal market in search of yield, credit quality and price stability.

As the Federal Reserve’s Operation Twist program removes nearly a quarter of long-dated Treasuries from the market, this drives down interest rates on long-term bonds, making municipal bonds an even more compelling alternative for liability driven investors seeking high-quality, long-duration assets.

Substantial Infrastructure Needs In The U.S.

The country’s continuing infrastructure needs require approximately $210 to $280 billion of tax-exempt borrowing annually for new capital projects. A refinancing wave is expected for 2012, as municipal issuers take advantage of current low interest rates and retire higher-coupon bonds.

If refinancing supply accelerates beyond demand from reinvesting maturities and coupon income, or investor appetite is diverted to cash or stocks, rates might be pushed higher to absorb the projected new issuance. To date, the trend of limited bond issuance persists, driving yields even lower.

Municipal Bond Outlook for 2012

Credit-intensive revenue bond sectors that used to be covered by monoline insurers including airports, essential service utility and healthcare bonds are favored and recommended.

These high-quality issuers with strong credit characteristics and revenues are better insulated from economic slowdowns and potential political tampering. As retail investors lack the time, expertise or access to analyze and monitor these revenue bond credits, this lack of interest has created inefficiency.

Weaker demand for revenue bonds from retail buyers can result in higher yields than would be justified by the sector’s strong credit fundamentals. The potential excess income over general obligations from single-A revenue bonds has increased since the significant decrease in bond insurance enhancements in the wake of the global financial crisis.

For long-term investors, intermediate municipals can offer a better balance between total returns and volatility. Over the 10 years ended December 31, 2011, intermediate municipals (as represented by the Barclays Capital 3-10 Year Municipal Index) produced annualized investment returns that were 88% of the returns generated by the Barclays Long Municipal index, with only 51% of the volatility of returns.

The yield curve will remain steep in 2012, with short rates anchored by the Federal Reserve’s stated commitment to maintain accommodative policy. In this environment, municipal bond investors will benefit from the incremental yield of high-grade

intermediate bonds.

The direction of longer interest rates is more difficult to predict, so avoid bonds where duration increases with rising interest rates. Instead, focus on sector and security selection to seek excess income in the face of an uncertain economic and interest rate environment.

While it is unlikely that the market will repeat the total returns generated during the market rally of 2011, expect high-grade intermediate municipal bonds to continue to provide attractive after-tax income, with stable credit quality and relatively low volatility. Moreover, as the credit cycle turns, expect municipal after-tax returns to exceed those of Treasuries plus inflation.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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