Everyone is watching the Treasury market for the slightest inch upward in interest rates. Financial advisors with clients in tax-free muni bonds are likely to be particularly interested. Their lips probably are posing the same question: Are munis still worth the premium? The answer depends on the rise of T-bills, the clients' tax status, Washington's whims on tax exemptions, and to a lesser extent, on the financial health of some volatile city governments.
If news reports of the city attorney in bankrupt San Bernardino telling residents to arm themselves -- because their police department has been decimated by cuts -- isn't enough to frighten bond holders, Wall Street is adding its own hand-wringing.
“Indeed, muni bonds are 'rich' and could be headed for a relative performance decline,” proclaimed Thomson Reuters' senior market strategist, Daniel Berger, in mid-October. “We are worried that the best relative performance for the long end may have already been achieved.”
Richard Ciccarone, the managing director and chief research officer of McDonnell Investment Management, in Chicago, can see room for concern. “AAA general obligation tax-free municipal bonds are trading at their lowest yields in 48 years,” Ciccarone says. In quoting the latest Bond Buyer Index data, Ciccarone has to admit the numbers are historic. The earliest average yield for the oldest index of 20-year muni bonds shows the average yield from January 7, 1965, to January 24, 2013, was 6.09%. But the lowest weekly average in all that time, 3.54% -- close to half the historical average -- happened this January. The high of 13.44% occurred 31 years ago.
“When was the last time we had a consistent average in this Bond Buyer Index that stayed below 4%?” Ciccarone asks. The answer is the 30-year period following the the Great Depression. According to the index, the muni bond yield didn't move up to 4% until 1968. But we didn't have a depression this time, Ciccarone points out. Yes, we did experience diminished expectations of economic growth for some time, eerily similar to today. But we have also seen leverage and indebtedness come down in the consumer, corporate, state and local sectors -- just not on the federal side. “So this could stick around for awhile,” he says, “but maybe not for 30 years.” He could see five or 10 though.
For these reasons and the likelihood that the Fed will finally allow interest rates to rise, Ciccarone wouldn't go long muni bonds. Instead, he favors short and intermediate bonds -- and only those of high credit quality. “The yields in munis aren't paying enough over Treasurys to offset those weaker bonds,” he says. Public pension liabilities risk has increased over the last few years, “so that's reason to be more conservative,” adds Ciccarone, who is also president, CEO, and a majority owner of Merrill Research Services LLC, a municipal database research company in Hiawatha, Iowa.
But there are some brighter spots, like the modest but steady increase in the cities' general funds rate, an indication of cash on hand (normally a city’s largest discretionary fund used for the general operations), which jumped from 81 in 2010 to 94 in 2011 and continued to 96 last year. The chart below shows how many days cities can support their general funds and government account funds with cash, based on their outflows. The general fund is used to pay the general operating expenses of a city. The government account can be used for debt service and redevelopment funds, but would not be used for enterprise funds such as the water system, and could not go for fiduciary funds such as for pensions. Ciccarone said that often cities pull funds from the government account to support the general fund.
Bond selection has become key though since pockets of economic distress still mark the national landscape. “There are some great opportunities in the municipal bond world,” says Rex Macey, CFA, CIMA, CFP, and SVP and chief investment officer for Wilmington Trust Investment Advisors, a Delaware-based advisor to high-net-worth clients. “People tend to treat muni bonds as homogeneous zones,” even though municipalities can vary widely, says Macey. He also agrees that “it's important to watch inflation and taxes, as well as rising interest rates, which will be a concern.”
Macey's remarks to FA-Mag on January 15 proved prophetic. On Jan. 28, Black Rock's Russ Koesterich, CFA, and the iShares global chief investment strategist, declared on his blog that “we are finally witnessing the long-awaited rise in rates.” Treasurys had just touched 1.94 percent on Friday, Jan. 25.
What if the turn-up persists? Should bond holders run for the doors? No, writes Koesterich, not for those with one-plus year horizons anyway. After all, the iShares National AMT-Free Muni Bond ETF delivered a tax equivalent distribution yield for the year ending Jan. 28 of 4.05%.
And not so fast, James Colby, chief municipal strategist at Market Vectors ETFs, would say, since their Intermediate Muni ETF (ITM) has a three-year average return of 6.90%.
With the higher tax rates for incomes of $400,000 and up, those in a 35 percent to 39.6 percent tax bracket have even more to gain now from a tax-free coupon, says Colby. As for municipal credit-quality fears, Colby points out that defaults may affect a small number of investors, but not every issuer in the state, let alone the country. Choose your investment wisely he advises. “Our ETFs have no exposure greater than 4 percent or 5 percent to any one name.”