Where are Municipals Headed in the Second Half

With such strong performance in the first half of 2014 and interest rates at such low levels already, one would think that the municipal bond market has run its course and can’t possibly continue to produce positive returns. The Barclays Municipal Index is up 5.83% on a year-to-date basis as of 06/24/2014, versus a return of 5.50% for the S&P 500 for the same time period. I still believe a good case can be made for the municipal bond market to continue providing positive returns for the remainder of 2014. While some factors have changed since the beginning of the year – such as relative cheapness – others remain the same (i.e. taxes, issuance, and demand for income) and can serve as strong drivers for continued positive performance.

Now that we are in June and tax season has passed for most Americans, the sticker shock of new taxes and the realization that total federal taxes are over 40%, has hit most high income earners on the head like a ton of bricks. In my opinion, these high income earners will do whatever they can to reduce 2014’s tax bill even if that means purchasing municipal bonds at these perceived low yields. These retail investors have always been the backbone of the municipal market and I believe they should continue to drive it for the remainder of 2014.

While some of the relative cheapness of municipal bonds has been taken out of the market since the beginning of the year with 10-year AAA yields falling from 100% of equivalent U.S. Treasuries to 89%, all one has to do is look at good quality A-rated bonds to find compelling value. Going from AAA to A-rated bonds offers a pick-up of approximately 63 basis points and minimal credit risk. A-rated bonds still offer yields above equivalent U.S. Treasuries and that’s not even factoring in tax equivalent yields. Even with the current low yields, once the tax equivalent yields are factored, investors should find that municipal bonds offer an alternative and on a risk-adjusted basis.

New supply of municipal bonds should continue to be a strong driver for returns for the remainder of 2014. Even with some of the more notable deals so far, new issuance has decreased approximately 18% on a year-to-date basis versus the same period last year, and I expect this trend to continue into year end. Low supply and large cash reserves from bonds maturing and being redeemed could put a cap on higher municipal yields and investors should continue buying bonds until something changes the dynamics of the market.

Finally, the term “don’t fight the Fed” is still as relevant now as it was at the beginning of the year. With short-term interest rates at or close to 0%, the Federal Reserve is still pumping massive amounts of liquidity into the economy and providing powerful returns for financial assets. While some economic indicators are showing slight signs of strength, keep in mind that it’s from very depressed levels and any sort of tightening will likely derail the economy quickly. This risk might keep the Federal Reserve from raising short-term interest rates until 2016, and even then it should be minimal. This policy could keep a cap on long-term interest rates for the near future.

These are just some of the factors that I believe should provide a strong support system for the municipal bond market for the remainder of 2014. While interest rates may not go much lower from this point without an unexpected surprise, I believe that municipal bonds will continue to outperform its taxable counterparts and continue to provide strong returns.

CRN: 061214-4240R

An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Municipal Disclosures webpage. Please see the Disclosureswebpage for additional risk information at www.aamlive.com/blog/about/disclosures


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