The markets have been in fits since mid-May, when Federal Reserve Chairman Ben Bernanke planted the seed that the central bank’s prolonged asset buying program would start winding down. Many investors were gripped with irrational panic, a so-called “taper tantrum” that roiled equity and fixed income markets — including municipal bonds. Rafael Costas, senior vice president and co-director of our municipal bond department, believes the early summer swoon sweeping the muni markets is unfounded and should be temporary, but the core reason for investing in the sector remains solid: long-term tax-free income potential.
In June, many muni investors decided they no longer wanted to play, leading to large outflows in the sector. The muni market is no stranger to such irrational sprees. As a long-term investor, Costas has ridden out similar short-term panics before, but that doesn’t mean there isn’t some short-term pain. He remembers the last big freak-out, back in 2010, and why he thinks the situation is much different today.
“In 2010, a well-known non-muni analyst got on national TV and scared a lot of people into believing there would be a lot of defaults. That didn’t turn out to be true, but unfortunately it panicked a lot of people. This time is different. There are some isolated issues, but we don’t see real concerns out there affecting the muni market generally in terms of credit. We don’t expect a spike in defaults. We’re not looking at a recession, we’re looking at a recovery; not a great one, but at least things appear headed in a positive direction. So in our view, this [volatility] is strictly based on technicals of supply and demand.
“What we are going through in the muni market is what we’re calling now a ‘taper tantrum.’ All fixed income is suffering, but munis, because they are a smaller market driven by a lot of retail investor flows, sometimes choke on either too much supply or can’t handle the sudden, big shifts in demand, especially on the down side.”
In the week ended June 26 alone, investors pulled some $4.8 billion out of muni funds.1 Costas said many are left wondering when the bleeding will end. His answer: “It’s hard to say.” One thing he does know, however, is that eventually, the sector will bottom, and higher yields that have come about will attract many income-seeking investors back.
“It feels like forever when you’re in the middle of one of these periods. But it [the muni market] will eventually stabilize. It needs to stabilize more from the demand side, but people have started realizing when yields rise, there is a growing opportunity to increase their income, which is what we think this asset class is for.
“We’re hearing a lot of talk about the growing opportunity of this asset class; the lower prices go, the greater opportunity there is. For people who’ve been sitting on the sidelines, waiting for rates to go up – the future is here. At times like these, people tend to focus onthe price of their investments, but you have to remember that if you got into this asset class for income, the picture is getting better. It’s an unpleasant way to get there, but that’s how it works. Prices go down, yields go up, or prices go up and yields go down. You can’t have it both ways. We also have to remember that we’re getting off a period of roughly 50-year lows in terms of yields. So that couldn’t go on forever.”
That all said, Costas said it’s important for investors to manage expectations once the selloff runs its course. Prices probably won’t revert back to prior peaks. However, the fundamentals look pretty good, in his view.
“Corporate America has been rightsizing its budgets and cleaning its balance sheets; municipalities and states have been doing the same thing. They’ve been rightsizing. They’re also looking at things like pension obligations coming due that they owe to their employees, and they’re trying to negotiate on those issues. They’re also looking at growing health care expenditures on the Medicaid side, and these are significant expenses. A lot of them may be saying, ‘this may not be the time to be taking on new debt. We’ll issue for things we have to take care of.’ Optional, ‘nice-to-have’ projects are probably getting put aside. So supply is not growing anywhere near as quickly as the investment bankers would like to see it.
But that, again, helps give support to the price equation. On the demand side, you can’t do much about mass psychology, other than try to educate investors and hope they listen.”
One last reminder Costas has for investors swept into a fit of market panic: step back and think about future goals, and reasons for investing in the asset class in the first place.
“We had a couple of good runs in terms of price appreciation the last couple of years; now we’re giving some of that back. But income is the one consistent thing. Lost in all of this [market panic] has been the value creation in terms of the tax-free income perspective. People seem to be forgetting that.”
All investments involve risk, including possible loss of principal. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in a portfolio adjust to a rise in interest rates, the portfolio’s value may decline. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.
Dividends are generally subject to state and local taxes, if any. For investors subject to the alternative minimum tax, a small portion of dividends may be taxable. Distributions of capital gains are generally taxable.
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