Municipal bonds have fallen in price recently

The price drop is not due to a new significant credit event or default, but rather, the decline is being driven by a host of other factors such as rising interest rates and a lack of liquidity stemming from increasing municipal supply, uncertainty surrounding the extension of Build America Bonds and the Bush tax cuts, and reduced investor demand. While municipal bond price volatility may continue into the beginning of 2011, we believe that municipal bonds still offer value over a long-term time horizon.

 

A general rise in interest rates

Treasury yields have risen causing bond prices to decline. Ten-year maturity Treasury yields have moved 0.50% higher since a low of 2.38% on October 8 to 2.88% on November 17. Meanwhile 30-year maturity Treasury yields have increased by over 0.75% from a low of 3.51% on August 31 to 4.29% on November 17. Treasury yields have risen partly because of the market’s unease surrounding the long-term impact of QE2 (Quantitative Easing II). Although the goal of QE2 was to keep interest rates low and increase investor confidence, the opposite has happened since the program was announced. Additionally, the increase in the 30-year yields has had a greater impact on the municipal market, as most of the new supply is for longer-dated issuance in which pricing is driven by 30-year Treasury yields. Municipal bond yields, as well as other fixed-income asset class yields such as corporate bonds, generally move in conjunction with Treasury yields. While the rise in municipal bond yields is partly attributable to the rise in Treasury yields, municipal bond yields have risen more than the rise in Treasury yields due to a lack of liquidity stemming from the factors cited further in this document.

Greater current and potential for future increases in tax-exempt municipal bond supply

• Current supply increasing due to new issuance and tobacco related selling

Additionally, the rating agency S&P recently downgraded tobacco bonds. Although this move was well-telegraphed to the market, tobacco bond prices fell sharply. While American Century Investments® is underweight the sector, other competitors held larger positions which hurt their performance and has caused investors to withdraw money. To raise funds to meet investor redemptions, the fund companies have sold higher quality municipal bonds, dragging down the entire municipal sector. Additionally, closed end mutual funds, which are levered and therefore have sustained larger price declines, have been selling as well.

• Future supply due to Build America Bonds (BABs) program extension uncertainty

The election outcome which resulted in the Republicans gaining control of the House of

Representatives increased the uncertainty surrounding the renewal of the Build America Bonds

(BABs) program. Republicans are considered less likely to favor BABs, which are municipal bonds that have been issued in the taxable market and receive a 35% federal government subsidy. This issuance has reduced municipal supply by roughly 25% over the last year. The potential for the cessation of the program has caused tax-exempt municipal prices to fall in advance of a potential significant increase in supply as these formally taxable municipal bonds re-enter the tax-exempt market.

Uncertainty over the extension of the Bush tax cuts

Earlier in the year it appeared as if the Bush tax cuts would be eliminated for high income earners which would have raised their tax rates by 3% plus. Municipal bonds are more attractive in an environment of higher taxes. If taxes are held at current levels, high income investors may remove some of the value of the tax exemption of municipal bonds.

 

Less municipal bond demand

Traditional municipal buyers are waiting for better entry points into the sector and have reduced purchases due to uncertainty around the extension of the BAB program as well the Bush tax cuts. Additionally, November 30 represents the fiscal year end for most Wall Street dealers. Heading into year-end, dealers are looking to reduce their holdings of securities and are less willing to buy municipal bonds. Therefore the increased selling mentioned above has not been met with a commensurate increase in demand.

 

Outlook

All the factors cited above point to continued volatility in municipal bond prices which could continue into the first part of 2011. Assuming interest rates remain in a range, our fixed income team believes that investors should use the near-term weakness in municipal bonds as a potential buying opportunity. We believe that municipal bonds offer value over a long-term time horizon. The required revenue needed to close the $1.5 trillion Federal budget deficit points to the likelihood of higher taxes at some point in the future, which should be supportive of municipal bonds

 

The opinions expressed are those of the portfolio investment team and are no guarantee of the future performance of any American Century Investments portfolio. Statements regarding specific holdings represent personal views and compensation has not been received in connection with such views. This information is not intended to serve as investment advice.

 

American Century Investment Services, Inc., Distributor

©2010 American Century Proprietary Holdings, Inc. All rights reserved.

www.americancentury.com

 

 

 

 

 

 

 

 

 

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