While much of the world was focused on European funding concerns and potential sovereign default for the first half of 2010, the latter half of the year brought attention to Municipals. Given significant state liabilities, municipal debt yields rose substantially and at a far faster clip than nearly all other areas of the bond market. With increased funding costs, and funds flowing out en mass by investors, several analysts have brought up the possibility of a Muni debt crisis.
The fundamentals do not look promising, but some politicians have begun to act to reduce their state budgets. How is the market beginning to react to this? Let's take a look at the price ratio of the Municipal Bond ETF (TFI) relative to the Vanguard Total Bond Market ETF (BND). As a reminder, a rising price ratio means the numerator/TFI is outperforming (up more/down less) the denominator (BND). Think of it as a way of seeing if yield spreads between Munis relative to the highest rated areas of the bond market are diverging or compressing.
We can see from the chart above (click to enlarge) that yield spreads have gone through a few periods of collapsing and diverging at different times during the past three years. Municipal bonds on average performed quite poorly since September 2010, but have shown impressive relative strength in recent weeks. It appears as though the price ratio may be in the midst of a “V” like motion off of its relative lows. Whether this is justified or not can only be borne out in the fullness of time, but investors who have shied away from Munis may want to consider now to be an interesting time to revise their outlook on Muni defaults.
Disclosure: I am long BND. The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.