As anyone who has been paying attention knows, bond yields have started to creep up over the last month as talk of Fed tapering, concerns about the economy being either too strong or too weak, and the unwinding of the Japanese Yen carry trade have all hit home. This rapid rise in yields, about 0.5% on the ten-year treasury, has surely caused a lot of heartburn and consternation for investors in all manner of fixed income investments and income producing securities.
Yet, the increased volatility in these sectors of the market have also created some interesting investment opportunities for those with cash to deploy, and the courage to bear some volatility. In particular, this article is about one such sector which has seen a remarkable and unjustified decline; municipal bonds.
Let's start with a brief primer for those new to the municipal bond markets (read my articles here and here for a more in-depth look). Municipal bonds or muni bonds are issued by states and local governments, offer coupon payments that are federally tax free (and sometimes state and local tax free depending on the bond and where you live), and have very low default rates. In order to determine before tax equivalent yields from a municipal bond, you use the following formula:
Before Tax Rate = Muni Rate/(1-Tax Rate)
So an investor in the 39% tax bracket investing in a 5% YTM bond is earning the equivalent of 8.2% on a regular taxable bond.
With the basics out of the way, let me talk about why munis may now (or in the next few weeks) be presenting one of the best buying opportunities in years. First, it's important to realize that historically, municipal bonds always traded at about 75-85% of the yield on comparable maturity treasuries. This held true for many years as the graph below shows.
Here the red line is an index of very safe municipal bonds while the blue line is the treasury rates. Notice that from 1998 through 2008, the red line is always below the blue line - treasuries always yielded more than munis because treasuries are taxable and munis are not, and both have roughly similar levels of safety.
Then the recession came along.
Treasury yields plummeted as investors piled into the safe haven, while muni yields went through the roof as investors sold any assets they could (including municipal bonds) at fire sale prices as if the world were about to end. That peak yield of about 6% achieved in mid-2008 was the highest muni yield in many years and for the first time in more than a decade Treasuries traded below AAA municipal bonds in yields. The situation likely would have reversed by now with treasuries trading at yields above municipals again by now if not for two events. By mid-2009, the markets realized the world wasn't facing economic Armageddon and Treasuries and municipals were trading at close to equivalent with Treasuries having moved up and municipals having moved down.
Then came Meredith Whitney and the great municipal/Europe scare of 2011.
Ms. Whitney, while undoubtedly a very fine banking analyst, was, like many commentators, extremely concerned about the health of a variety of municipalities around the country. In late 2010 and early 2011 she appeared on TV stating with confidence that the country was headed for a wide-spread plague of municipal defaults with many multi-billion dollar defaults looming. At about the same time, the European Union looked like it might implode and municipal bond rates shot back up to well above their ten year average rate.
Despite the dire warnings, the municipal markets settled down, default rates did not spike to any appreciable degree (though more bonds did default in 2011 than in the past few years). Then in late 2011, the Fed went into overdrive trying to stimulate the economy with the QE program. The result was that interest rates on Treasuries collapsed. Municipal bond yields also fell as investors went searching for yield and the general economic picture improved, but muni rates did not fall anywhere near as much as Treasury rates did. That has pretty much been the situation for the last 18-24 months.
Fast forward to about a month ago though, and things began to change again. Treasury rates started to move up, as did municipal rates, but muni rates moved up more than Treasuries! While the specter of eventually rising rates will hurt muni bonds, that pain has been exaggerated over the last month. Given that a recovered municipal market is almost certain to once again trade at 75-85% of the Treasury market, and given that Treasury yields fell a lot farther than muni yields, muni yields should be rising less than Treasury yields. Yet in the last month, 30 year Treasuries have risen 20 bps vs. a 52 bp rise for municipals with no major news to explain the discrepancy.
So what's going on here? This move has been driven by record outflows from muni ETFs as sophisticated muni bond investors look to get ahead of rising rates. But I believe that muni investors have got the cart before the horse in this case. Municipal bond ETFs have generally fallen to 2-3 year lows and have virtually all declined more quickly than other fixed income investments despite the fact that the normalization of the Treasury/Muni relationship should result in less of a decline in munis vs. other types of bonds.
This presents a unique opportunity for investors in municipal bonds, both sophisticated and novice.
Assuming that the economy is starting to get back to normal, then rates on munis and all other bonds will rise probably to about the same level they were at in the mid-2000s. This would take the Bond Buyer 20 index shown above back to a yield of about 4.7%. This 4.7% yield on the 20 Bond Index munis would imply a 5.85% yield on 20 year treasury bonds - a staggering ~3% above where they are now. With the index already at about 4%, much of that maximum possible yield increase has already occurred as such, investors should look at the muni markets now. Ultimately, unless the Treasury rates skyrocket very quickly, much more quickly than the Fed has seemed willing to accept, then the temporary surge in muni interest rates is likely to reverse or stay stagnant while Treasuries and other bonds catch up over time.
More sophisticated investors could look at going long munis and shorting other bonds that are more closely correlated with Treasury rates (like high grade corporate bonds), and then waiting for the historical relationship between munis and treasuries to normalize.
If it becomes clear that the economy is not recovering as expected, then the Fed will certainly keep rates low for the next few years meaning that municipal yields should drop back more sharply than the yields on other bonds given that they have risen faster.
Municipal CEFs are probably one of the easiest ways to play this opportunity with most names now trading at or below NAV. Suitable CEFs include (BFZ), (BJZ), (MUC), (MYC), (MCA), (BFO), (BZM), (MNE), (NMO), (NMA), (NMZ), (MHN), (MYN), (BLH), (BSE), (BQH), (BNY), (BFY),(MYJ), (MJI), (BLJ), (BNJ), (MZA), (MYM), (MIY), (MPA), (BPS), (BHV), (MHE), (NUV), (NIO), (NAD), (NZF), (NPM), (NQM), (NPP), (NQU), (PML), (PMX), (BFK), (BTT), (IQI), (IIM), (VMO), (VKI), (VGM), (VKQ), (BYM), (SUB), (SMB), (SMMU), (MUB), (MUNI), (KTF), (IMC), , and (MMU).
There are high grade/agency names out there that might make suitable shorts against a long position in municipals such as (AGZ), but a broader bond ETF like (BND) has the advantage of being very liquid which is always a particularly important consideration when dealing with short positions.