By Mike McDermott
In today’s zero interest rate environment, income investors are running out of options. Yields on treasuries have been compressed to historic lows. Bank CDs and deposit accounts aren’t generating enough income to cover account maintenance costs. And equity positions that pay dividends are becoming more risky as the economy stumbles.
This low yield environment isn’t an accident, of course…
The Fed has pushed rates down intentionally to force investors to put their capital to work in more “productive” areas. We’ll leave the logic of the Fed’s actions for a different discussion another day, but right now, let’s take a look at the effect this rate pressure is putting on the municipal bond market.
Municipal bonds have enjoyed a bull market over the past several quarters as investors plow capital into securities that are generating income. Muni’s have become especially attractive because their yields are significantly higher than treasuries, and the coupon payments for most muni bonds are exempt from income tax.
As more capital flows into this area, prices have been pushed higher, and of course yields have been forced lower. Today, 5-year municipal bond yields are close to 0.9% – a testament to the popularity of this asset class.
But despite the strong historical performance, a number of storm clouds are brewing. Over the weekend, the Wall Street Journal published an article titled Muni Bonds Seem Poised For Pain. The risks are mounting and while the muni market is still holding up well, there is a bearish case building which could set up an attractive short opportunity in the near future.
There are essentially four bearish issues with potential to derail the positive trend in municipal bonds. Keep in mind that unlike equities, fixed income products have a theoretical maximum value (principal plus expected interest payments) while the downside risk can still be material (perceived risk of default, or higher rate environment).
If one or more of these issues rises to the forefront, investors could quickly exit the market, sending muni prices sharply lower…
Currently, interest payments on most municipal bonds are tax deductible. This means that municipalities can offer a lower rate than their corporate bond counterparts – and still be more attractive to investors.
Investors simply have to look at the taxable equivalent rate to determine whether corporate bonds with the same risk rating are ultimately a better deal. Since most ratings agencies (and general public perspective) put the risk of default higher for corporations than for municipalities, the risk-adjusted – tax-adjusted return for munis has been very favorable.
But what happens if the tax deductible status is changed?
The Obama administration has suggested changes to the tax code which include restrictions on the tax deductible arrangement. The proposal in play right now sets the tax deductability cap at 28% instead of 35%. This may seem like a small shift, but it could be enough to sway wealthy investors to adjust allocations in favor of highly rated corporate bonds.
From an accounting perspective, muni rates would have to be a few basis points higher to match the corporate equivalent. Higher rates mean lower prices – and investors re-allocating a portion of their holdings out of muni positions could pressure the entire group.
Issuance Levels to Increase
The WSJ article also noted that the level of muni bond issuance has been historically low this year. Through the month of August, municipal bond issuance has been roughly $20 billion per month, compared to an average of $30 billion.
A 30% drop in the supply of new bonds to the market can have a positive effect on prices. If investor demand remains stable, the natural result would be higher prices.
But investor demand has NOT remained stable. So we’re currently in an environment with high demand for yield securities, and low issuance of municipal bond offerings. As the number of offerings pick up in coming months (and municipalities will certainly need to raise capital), the supply / demand imbalance should be resolved with muni prices suffering as a result.
Tax Receipts – Credit Risk
Like the broad economy, municipal markets are dealing with high unemployment, low property values, and consumer confidence challenges that result in lower spending and lower tax receipts.
Certain municipal issuances are in good shape – those backed by revenue tied to water treatment centers, power plants, or other stable revenue generators.
But the majority of municipalities are affected by the US economy – and their ability to collect tax receipts and make payment on their obligations rises and falls with the ability of constituents to pay taxes.
With foreclosure rates still very high, and no improvement in unemployment, municipalities are bracing for more revenue cuts – and investors in muni bonds should be aware of the mounting risks.
Current vs. Historical Rates
As mentioned earlier, the average yield on a 5-year municipal bond is 0.9%. This compares with a historical average of 2.37%.
As long as the Fed continues to press for low interest rates, municipal bonds will trade at a lower than “historical” yield. But considering the fact that we’re at less than half of the “norm” there is plenty of room for rising yields (and falling prices).
If we begin to enter a more inflationary environment (and with so much stimulus capital in the system, many argue this is only a matter of time), the Fed will be be forced to reverse course and tighten.
A more hawkish environment would drastically change the playing field for municipal bonds – and would be the type of scenario that could leave investors leaning the wrong way. If higher rates force a sharp contraction in investment capital dedicated to municipal bonds, once again we could see a dramatic shift in trend.
Don’t Forget The Bullish Case
Of course, as Mercenaries, we aren’t interested in making bold predictions as much as developing scenarios and entering trades as the price action confirms the trade opportunity.
In the case of municipal bonds, there are still important forces which could continue to support higher prices.
- Unfunded Pensions – Both corporate and municipal pension funds are largely under-funded. If a material amount of new capital is put to work in these institutional investment pools, it could trigger a sharp rise in demand for municipal bonds.
- Fed Bailout – While many states and cities are struggling with tax revenue and unbalanced budgets, there is still a significant chance that the Fed could bail out individual municipalities. If this happens, credit risk will evaporate – supporting prices.
- Negative Carry – Even if our bearish scenario eventually plays out for municipal bonds, a short position can be an expensive proposition. Shorting an ETF that owns municipal bonds requires the seller to make the interest payment – leading to a negative cash-flow situation while we wait for the trade to play out.
The problem with many of these ETFs is liquidity. With only a few thousand shares trading per day, it can be difficult to move in and out of a position without significant slippage. It can be even more difficult to borrow an ETF for shorting.
The iShares S&P National Municipal Bd (MUB) looks like the best candidate for shorting when the time is right.
We’re watching the current resistance point carefully – along with the fundamental issues that could trigger a selloff. In this turbulent market environment, it’s important to set up potential trading scenarios while still protecting capital and keeping your trading capital dry.