The Rally Nobody Noticed: Municipal Bonds

by: Larry Swedroe

Summary

The performance of municipal bonds has been helped in recent years due to the actions states and municipalities took to improve their budget situations.

There has also been a significant change in the ownership composition of municipals, with increased demand from investors other than households.

Limit your holdings to only AAA/AA-rated bonds and also make sure that they are either general obligation or essential service revenue bonds.

Historically, in terms of yields, because of their federal tax exemption, AAA-rated municipal bonds have traded at a discount to Treasuries. Over the long term, AAA-rated intermediate-term municipal bond yields have typically traded between 75-85 percent of the yields on similar maturity Treasuries. For example, for most of the period from 2001 through 2007 five-year Treasuries yields traded between 70 percent and 85 percent of the yields on five-year AAA-rated munis. And they never rose above 100 percent.

The financial crisis that began in late 2007 changed all of that. For a long time the flight to the higher quality and greater liquidity provided by Treasury bonds led municipal bond yields to be even higher than Treasury yields. The peak of the flight to safety came in early 2010 with municipals yielding as much as 160 percent of Treasuries.

Even after the worst of the financial crisis was over, municipal bond yields continued to trade at a premium. One reason was the now infamous forecast made by Meredith Whitney which "spooked" many investors and led to a massive exodus by retail investors from municipal bond funds. On December 19, 2010, while appearing on 60 Minutes, Ms. Whitney predicted a wave of defaults that would occur in the municipal bond market in 2011: "You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults." We know now that not only did municipals experience very few defaults, but municipal bond funds continued to produce good returns. We can see this by comparing the returns of the Vanguard Intermediate-Term Tax-Exempt Fund (MUTF:VWITX) with an average duration of 5.4 years with the returns of the Vanguard Intermediate-Term Treasury Fund (MUTF:VFITX) with an average duration of 5.2 years. Keep in mind that the returns are total returns and are pretax returns. Data is from Morningstar.

Fund

2011 Return (%)

2012 Return (%)

2013 Return

(%)

Total Return

(%)

VWITX (Munis)

9.6

5.7

-1.6

14.0

VFITX (Treasuries)

9.8

2.7

-2.8

9.6

Click to enlarge

Overcoming the headline defaults, the total return of VWITX from 2011 through 2013 was 14.0 percent, outperforming VFITX's total return of 9.6 percent by 4.4 percent. And this is even before considering the impact of taxes. And the outperformance continued in the first two months of 2014, as VWITX returned 2.7 percent while VFITX returned 1.9 percent.

One reason for the outperformance is that the yield spreads have narrowed. According to Bloomberg and Yahoo, as of March 31st the five-year Treasury was yielding 1.74 percent and AAA rated-municipals were yielding 1.29 percent, just 74 percent of the Treasury yield. The yield on the 10-year Treasury was 2.72 percent and AAA-rated munis were yielding 2.51 percent, a still very attractive 92 percent of the Treasury yield.

The performance of municipal bonds has been helped in recent years as the actions states and municipalities took to improve their budget situations, along with the public's reluctance to improve more spending, has resulted in a reduction in the supply of bonds. According to the Federal Reserve's recent Flow of Funds release, the municipal market continued its multi‐year pattern of shrinking, as total municipal securities at the end of 2013 declined 1.2 percent year‐over-year to $3.67 trillion. This marks the third consecutive year of declines and the lowest level since the end of 2009.

The amount of outstanding municipal securities reduces as new money issues fail to keep pace with redemptions and maturing bonds, essentially creating "net‐negative supply." Reduced supply has a positive impact on prices. And there doesn't appear to be anything on the horizon that would cause the declining trend to end anytime soon as issuers are reluctant to return to pre‐recession borrowing levels.

There has also been a significant change in the ownership composition of municipals, with increased demand from investors other than households. While the largest owners of municipal securities continue to be households, other investors have increased their holdings. U.S. banks increased their holdings by 14.7 percent in 2013. They now hold 11.3 percent of the market compared to only 6.1 percent in 2009. Property and casualty insurers increased their holdings by 1.4 percent, the first increase in five years. Households now represent 44.1 percent of municipal investors compared to 53.0 percent in 2005.

In summary municipal bonds are still alternatives for taxable investors. This is the case even for those not necessarily in the highest tax brackets when the maturity is beyond five years. So, if you haven't been a buyer of municipal bonds because you thought your lower tax bracket status made them unattractive, it's time to take another look and do the math. And if you've been scared off by dire forecasts of municipal defaults, it's also time to take another look. To make sure you minimize credit risks, I recommend that you follow the same buying parameters we use: Limit your holdings to only AAA/AA-rated bonds and also make sure that they are either general obligation or essential service revenue bonds. Bonds that fall within those parameters have historically experienced losses that are very close to zero. That certainly held true throughout the recent financial crisis and it even held true in the Great Depression.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.