@AmyLMagnotta, CFA, Brinker Capital
Municipal bonds have delivered very strong positive returns since Meredith Whitney famously predicted hundreds of billions in municipal defaults during a 60 Minutes interview in December 2010. Municipal bonds outperformed taxable bonds (Barclays Aggregate Index) by meaningful margins in both 2011 and 2012.
Municipal bonds have benefited from a favorable technical environment. New supply over the last few years has been light, and net new supply has been even lower as municipalities have taken advantage of low interest rates to refinance existing debt. While supply has been tight, investor demand for tax-free income has been extremely strong. Investors poured over $50 billion into municipal bond funds in 2012 and added $2.5 billion in the first week of 2013 (Source: ICI). This dynamic has been driving yields lower. The interest rate on 10-year munis fell to 1.73%, the equivalent to a 2.86% taxable yield for earners in the top tax bracket. Similar maturity Treasuries yield 1.83% (Source: Bloomberg, as of 1/15). We expect new supply to be met with continued strong demand from investors.
While technical factors have helped municipal bonds move higher, the underlying fundamentals of municipalities have also improved. States, unlike the federal government, must by law balance their budget each fiscal year (except for Vermont). They have had to make the tough choices and cut spending and programs. Tax revenues have rebounded, especially in high tax states like California. Last week California Governor Jerry Brown proposed a budget plan that would leave his state with a surplus in the next fiscal year, even after an increase in education and healthcare spending. Stable housing prices will also help local municipalities who rely primarily on property tax revenues to operate.
While we think municipal bonds are attractive for investors with taxable assets to invest, the sector is still not without issues. The tax-exempt status of municipal bonds survived the fiscal cliff deal unscathed, but the government could still see the sector as a potential source of revenue in the future which could weigh on the market. Underfunded pensions – like Illinois – remain a long-term issue for state and local governments. Puerto Rico, whose bonds are widely owned by municipal bond managers because of their triple tax exempt status, faces massive debt and significant underfunded pension liabilities and remains a credit risk that could spook the overall muni market. As a result, in our portfolios we continue to favor active municipal bond strategies that emphasize high quality issues.