March 11, 2010Highlights
Municipal Market Overview
Municipal bonds outperformed US Treasuries in February, supported by a light newissue calendar and positive inflows into municipal bond mutual funds. Municipal issuance in February, both tax-exempt and taxable, was $25.1 billion, with taxable Build America Bonds (BABs) accounting for 28% of the total. The figures were unsurprising, as primary market supply in February historically is considered below average. Market performance was further enhanced by a revival of the tender option bond programs.
Given heavy forthcoming supply of US government securities and renewed concern for rising inflation, many investors began to look at the 5- to 10-year area as the sweet spot on the yield curve. Additionally, with money market rates at all-time lows, investors moved to the intermediate part of the curve to pick up additional yield.
Making Headlines
Bankruptcy discussions by the city of Harrisburg, PA, refocused market attention on the fear of default risk. As concerns over state budget deficits continue to grow, state aid to local governments will be reduced dramatically, placing more pressure at the local level at a time when underfunded pension obligations and declining tax receipts continue to be major concerns.
Coincidentally, Moody's released an update to its default rate study, which continues to show strong credit quality among municipal bonds. The report found that only 54 municipal issues defaulted over the period 1970-2009, with 78% of those in the healthcare and housing sectors. Compared to corporate bonds, municipals proved much safer and provided higher recovery values. The default rate for investmentgrade municipals was only 0.06% compared to 2.5% for corporates. Recovery rates for defaulted municipals were almost 60% higher, with municipal bondholders recovering an average of $59.91 of par versus $37.50 for corporate bondholders.
With the federal deficit continuing to grow, Senators Wyden and Gregg introduced a bill to eliminate the tax exemption of municipal bonds by the end of 2010. The bill would also take away the BABs subsidy. Since the advent of the federal income tax in 1913, there have been four attempts to eliminate munis' tax-exempt status. The last attempt in 1968 met with strong state and local government resistance of the federal efforts to intrude upon their fiscal operations and with mistrust that any federal subsidy would be reduced or removed. We would note that opposition to the bill is extremely heavy and market participants see little chance of it moving forward.
By the Numbers
The S&P/Investortools Municipal Index returned 0.92% in February, with positive performance across the curve, led by intermediate maturities. Low yields in the very front end continued to encourage investors to move further out. The high yield index continued its strong run, outperforming the main index by 41 basis points. As for the sector indices, the pre-refunded index posted the lowest performance, at 0.34%, while the housing index provided the highest return, at 1.53%.
Monthly Change in Municipal and Treasury Yields
Municipal and Treasury Yield Curves, 2/28/10
Sources: Thomson Municipal Market Data; Bloomberg.
Municipal Market Monthly Performance Analysis
Source: Standard & Poor's/Investortools.
Strategy and Outlook
While fundamentals in the municipal market remain weak, favorable technicals continue to drive performance. We maintain our neutral duration strategy and our bias toward longer-dated bonds, as low yields in the front end of the curve continue to encourage risk taking further out. We continue to believe taxfree municipals are well positioned relative to other fixed income assets, given the safety factor cited earlier, limited supply and the appeal of their tax-exempt status amid the likelihood of higher tax rates.
Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable. A fund concentrating in a single state is subject to greater risk of adverse economic conditions and regulatory changes than a fund with broader geographical diversification. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. The performance shown for state-specific municipal bonds is not representative of the past or future performance of any specific BlackRock fund. Past performance is no guarantee of future results.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of March 10, 2010, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader.
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