The Municipal Bond Market: Current Risks, Opportunities and Tax Advantages
Municipal bonds posted impressive returns in the first quarter of this year and are poised for a strong 2014 thanks to low supply and improving fundamentals at both state and local levels. New issues are expected to drop to around $280 billion to $300 billion in 2014 – the lowest volume issued in the past decade (annual volume previously averaged more than $350 billion).
There’s been a lot of media attention concerning a few distressed issuers, namely Puerto Rico, Illinois and Detroit. Just recently, though, Detroit was successful in striking deals with its public employees, retirees and unlimited general obligation bondholder creditors. These agreements are likely to persuade other creditors to settle claims before the scheduled trial date in late July.
Despite recent defaults, a few bad apples do not spoil the whole bunch, and otherwise credit quality remains quite high. Most insiders observe that municipal bond defaults should continue to decline in 2014. There are more than 60,000 different issuers in the muni bond market, so it’s a matter of conducting the due diligence necessary to ensure you purchase a bond from a high-quality issuer. And thanks in part to the improved job market and economic growth yielding a higher tax base, there are increasingly more high-quality issuers than in recent years. In fact, Moody’s has upgraded its rating for state and local governments from negative to neutral.
Recently, states are hesitant to issue new debt in order to avoid meeting new interest payments. Therefore, today’s limited supply also serves to increase prices and the subsequent value of current issues, with a particularly positive outlook for municipal bonds in the 10- to 15-year maturity range.
There is one particular headwind on the horizon. As the economy continues to improve, albeit slowly, interest rates are likely to rise and investors who wish to unload their municipal bonds should be concerned about the potential for declines in value. Remember, as interest rates rise, bond prices typically decline and vice versa. One way to offset interest rate risk is to purchase shorter duration bonds. The longer the duration, the greater a bond’s price sensitivity to changes in interest rates.
One important question to ask yourself is why you want to own bonds in the first place. Are you seeking income and plan to hold the issue until maturity? If that’s the case, you needn’t worry much about interest rates or duration; your biggest concern is the quality of the issuer to avoid the chance of default. However, if you tend to buy and sell issues for the sake of portfolio diversification and/or total return opportunity, you’ll want to stay on top of prices, yields and the direction of interest rates.
The good news for investors is that yields on municipal bonds tend to be higher than the after-tax yield on other bonds. This current convergence of factors bodes well for the muni market for the rest of this year. Looking ahead, as state and local government economic fundamentals improve, we are likely to see an increase in municipal bond issues going forward, which will bring prices back down.